Spring is finally here. The pace of COVID-19 vaccinations in the U.S. has increased to three million doses administered daily and accelerating. We are on the road towards herd immunity from the pandemic and the prospect of returning to normal is on our horizon – doesn’t it feel great?!
So what does this mean for the economy? Normally, when the economy declines, it does so very rapidly and recovers slowly. This economic cycle is different, defying historical recovery norms in an extraordinary manner. We have recovered 32 million of the 40 million jobs lost due to the pandemic, including almost one million in March. At this pace, we will be back to full employment later this year or early next year. Our sense is we are at the cusp of a very strong economic recovery driven by unprecedented multi-trillion dollar federal stimulus programs, imminent widespread euphoria from the end of the pandemic and pent-up consumer spending demand. With $5 trillion of stimulus and infrastructure spending, economic growth may reach levels not seen since the post World War II era. All of this impacts our outlook for both fixed income and equity markets.
Intermediate and long term interest rates have moved higher since August but remain low, especially when considering progress made against COVID-19 and the strengthening of our economy. Fixed income returns, as measured by the Bloomberg Barclays US Aggregate Bond index, were -3.4% during the first quarter. Without the Fed’s $120 billion of monthly bond purchases, long term interest rates would be higher and returns lower. For perspective, the chart below compares the yield curve at March 31, 2021 with December 31, 2013. This was the most recent time the Fed’s short term interest rate target was the same as today (0-0.25%) and it was not buying bonds to support the economy. The record low yields on August 4, 2020 are also included for comparative measure.
Short term rates are closely anchored to the Fed’s interest rate target. The Fed has repeatedly stated “it is not even thinking about thinking about raising interest rates.” The Fed recognizes our country’s overwhelmingly fast recovery, but also acknowledges its disparate nature. Until industries such as travel and entertainment recover, they remain committed to supporting our economy with current forecasts indicating the first rate hike in 2024. Normally inflation expectations, strong economic growth or high federal debt ($28 trillion and growing) would place upward pressure on long term interest rates. As long as the Fed remains committed to its program of buying bonds to fund federal deficits and supporting economic growth, interest rates are unlikely to rise to historical levels.
As the economy recovers, the Fed will eventually begin tapering its bond purchases, causing some upward pressure on longer term interest rates. When this occurs, the value of bonds will likely decline but higher interest rates will make fixed income yields more attractive. We expect this normalization of interest rates to occur gradually as the economy strengthens and should not cause capital markets to destabilize.
So what could go wrong? Eventually the impact of the federal stimulus and accommodative Fed policy will fade and become an economic headwind rather than a tailwind. Higher taxes could adversely effect corporate earnings and investor sentiment, placing downward pressure on the markets. When the Fed eventually reduces the amount of bonds purchased to support the economy, other investors will need to fill the void to fund our deficits, and higher interest rates may be necessary to attract large scale bond buyers. Inflation is likely to rise from 2020 lows as the demand for goods and services in 2021 outpaces supply.
The Fed is keenly aware of these issues and is expected to proceed very cautiously in order to maintain orderly markets.
The domestic equity market was strong again during the first quarter. As we noted in the previous quarter’s market commentary, value stocks outperformed growth stocks in 14 of the last 14 economic recoveries by roughly 19% but still lag by 4% since the market low in March 2020. The valuation gap between value and growth remains significantly above long-term averages with value still considered relatively inexpensive.
Small cap stocks, on the other hand, have outperformed large caps in dramatic fashion over the past twelve months as shown by the above chart.
We expect these trends to continue as the economy strengthens, but it will not last forever. When economic momentum eventually slows, growth oriented and large cap companies may return to return the favor.
As noted in the following chart, the S&P 500 valuation is skewed by the concentration of the largest stocks in the index. If you exclude the ten largest stocks in the S&P 500, the “S&P 490” valuation is above average but not unreasonable. While equity valuations are high, a booming economy spanning the next couple of years could justify current prices. If so, earnings growth will likely compress P/E ratios towards historical averages rather than a market price correction.
In other words, high valuations do not necessarily imply a correction is imminent, but objectively we should expect lower returns if we are paying higher prices.
To mitigate potential risks of high domestic equity valuations, we’ve added a new position to client portfolios. The JP Morgan Hedged Equity fund invests in domestic large cap stocks while employing a disciplined quarterly options strategy to provide a hedge against drawdowns. Historically, this fund has been capable of capturing approximately two-thirds of the S&P 500 return while only experiencing half of the index volatility. We believe this fund can play a valuable role maintaining equity exposure when valuations are high and to mitigate portfolio volatility for moderate and conservative investors over the long term.
Emerging market and developed international equity returns during the first quarter were +2.3% and +3.5%, respectively, lagging domestic equity returns in spite of more attractive valuations. Over the long term, global equity returns will be a function of earnings growth and current valuations. The following chart bodes relatively well for investing beyond our borders today. Foreign equities are not only trading at some of their cheapest levels in the past 20 years relative to domestic, but also tend to be more cyclical in nature. Cyclical sectors include industries such as automobiles, retail, construction, financials, travel and entertainment. These areas of the global economy tend to outperform during strong recoveries. As the global pandemic subsides and more economies stabilize, we expect a convergence of economic growth and valuations between domestic and foreign equities.
Thanks for reading our market commentary. We welcome any questions you have and we look forward to our next portfolio review with you. Each member of the JRM Team has been fully vaccinated, and we cannot wait to meet with each of you in person again!
In other news, we are proud to announce that Lauren recently obtained her CERTIFIED FINANCIAL PLANNERTM professional designation. During the pandemic Lauren committed to earning this recognized standard of excellence for financial planning by completing CFP Board approved coursework and passing a comprehensive board examination. The curriculum covers the financial planning process, tax planning, employee benefits and retirement planning, estate planning, investment management and insurance. If you haven’t had your financial plan reviewed in some time, give her a call and she’ll take excellent care of you.
We are grateful for your trust and confidence. Please do not hesitate to reach out to us at any time.
The JRM Investment Counsel Team Jack, Phil and Lauren
