Q1 2021 Market and Economic Perspective

A quick glance:

  • U.S. economic activity is accelerating rapidly, and with expectations of even more fiscal spending on tap, a burst of rapid growth could persist into 2022.
  • The risk is on in global markets, as inflows to equities and growing earnings resulted in strong equity gains in the first quarter, as bonds remain under pressure.
  • The concept of a Goldilocks economy is not a new one, but the application of the term in the current environment is not as straightforward as it seems.

The first quarter of 2021 set the stage for a revival in confidence, economic activity and hope which is likely to propel the economy and global markets through the rest of the year. While we acknowledge the reality that Covid-19 is here to stay, and that we will be grappling with this virus and its mutations for years to come, the meaningful, sustained progress in terms of treatment and prevention of the spread of the virus has created the backdrop for an economic rebound unlike anything experienced, at least here in the U.S., since the post-war era. The bifurcation between different types of workers over the last year has produced a clear K-shaped recovery. Unemployment has remained high among service sector workers, while industries such as professional services and technology have been only modestly impacted, and areas such as construction have experienced a boom.

Stronger growth and higher inflation expectations resulted in a sharp steepening in the yield curve over the course of the quarter, which compounded the re-allocation away from defensive positioning that investors may have held coming out of the winter Covid-19 surge. More specifically, the S&P 500 posted a strong return for the quarter of +6.4%, which was bested by the return for small cap stocks of +12.7% as represented by the Russell 2000 Index. Outside of the U.S., stronger variants and issues with AstraZeneca’s vaccine, which was expected to be the most widely distributed vaccine in the European Union, has slowed the economic recovery in that region, and international developed stocks turned from out-performers in the fourth quarter of 2020 to under-performers in the first quarter. Bonds, as expected, continue to suffer from the dual headwinds of risk on trading and a steepening yield curve, while commodities and real estate, which typically exhibit positive correl ation to inflation were strongly positive for the quarter.

Overall, economic data in the United States, China and even Europe improved markedly over the course of the first quarter. Yet, the focus for economists and market participants seems to keep circling back to causation. With the Fed and other central banks seemingly locked into an accommodating posture for the coming quarters, the narrative that the markets, particularly the equity markets, cannot continue without this monetary policy crutch is one that continues to dominate for those who believe the market has come too far too fast after such a dramatic, concerted global decline in activity. Fears of a taper resulting from higher inflation created a meaningful spike in volatility in the first quarter, and the perception that the Fed could pull the punch bowl back too early is likely to fuel more pops in volatility over the coming months.

Goldilocks Economy....??
Goldilocks is to 2021 what unprecedented was to 2020. The term is everywhere, but it is important to note that historically, the term “Goldilocks economy” described a scenario in which the economy grows at a measured pace with controlled inflation. With that in mind, the term Goldilocks being used today denotes a slightly different form of balancing act, as U.S. economic growth is expected to be extremely robust, and inflation on a year-over-year basis could be well above target in the near term. This time, it refers to the balancing act necessary to create an environment in which both longer-duration growth stocks with limited fixed assets can perform along with the cyclical companies that typically dominate in a post-recession bounce. This dynamic is perceived as healthier for the markets, as it allows for greater participation in equity gains across the spectrum, versus the concentration in technology and technology proximate names that existed for much of 2019 and into 20 20.

The skepticism comes in when it comes to how this type of Goldilocks equity scenario will be delivered. In order for a broad equity market to move higher, a shift away from binary allocation between growth and cyclical names needs to take hold, based on optimism that the new version of the Goldilocks economy will be in place. This new economic vision is supported by the Fed’s commitment to be outcome based, rather than expectations based, in its decision making, and in the delivery of continued fiscal spending despite current budgetary pressures.

In the most basic of terms, it is willingness to believe that the Fed as well as the U.S. government are willing to risk overextending in order to fuel the rapid acceleration of the U.S. economy after a decade of slow growth (even with low interest rates). This is admittedly a tough pill to swallow. Deficit hawks are growing louder in Washington, and the Fed’s new focus on outcomes and delineating between transitory and sustained inflation is new; as such, the threat of policy missteps is worth noting.

Our view is that in the short term, both the Fed and Washington are likely to take the chance of providing too much stimulus to the economy. Inflation and growth have been below trend since the financial crisis, and with many pockets of the U.S. economy still struggling, there is plenty of cover for a continuation of the current plan to spend our way back to prosperity. That is often referred to as the reflation trade. My biggest fear and concern lies in the amount of leverage in the marketplace given the “free money” environment that has existed. We recently saw a scenario of leverage and concentration go wrong, leading to what many believe was the largest margin call in modern day history. It’s not the first and won’t be the last.

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