Global stocks continued to power upward this quarter from their pandemic bear market low on March 23, 2020. U.S. stocks, developed international stocks, and emerging-market stocks are now up an astonishing 80.6%, 74.8%, and 74.6%, respectively, since then. Clearly, it paid not to panic and get out of the markets last spring.
Due to expectations for a reinvigorated economy this year, the market has seen a “reflation rotation”: For a couple of quarters now, equity investors have been betting on more economically sensitive small caps and value stocks and eschewing large caps and previously highflying growth stocks.
The reflationary winds tore through the bond market as well. The prospect of higher growth and higher inflation caused interest rates to jump. The 10-year Treasury yield more than tripled from the historic low it set last August. Correspondingly, the core bond index fell 3.6%, suffering its worst quarter since 1981. On the flipside, floating-rate loans, which benefit from reflation, gained 1.8%. And most of the flexible, active bond strategies we invest with delivered positive returns this quarter, despite higher rates (and all outperformed core bonds).
Investment Outlook
The primary variables that will determine the direction of the economy and markets remain COVID-19 developments and the fiscal/monetary policy response. These currently imply a base case for a strong economic rebound, particularly in the United States but also globally. This will support the fundamentals underpinning higher-returning asset classes (stocks, credit sectors of the bond market) if interest rates do not move sharply higher.
At the current vaccination rate, experts estimate the United States could achieve herd immunity by late summer. Controlling the pandemic will enable us to start getting back to normal lives, boosting economic activity. The American Rescue Plan (ARP) Act, the massive fiscal stimulus enacted early in the new administration, will supercharge economic growth further. That should in turn feed into company earnings. Yet the Federal Reserve continues to reiterate that it will not preemptively raise interest rates. It intends to wait till it sees inflation above its 2% target for an extended period of time, a new policy that suggests this economic cycle has plenty of room to run.
So high economic growth, strong earnings growth, but low interest rates? Equity investors couldn’t ask for more. The main threat is our old friend valuation risk. However, stocks remain reasonably attractive relative to bonds.
Speaking of bonds, longer-term interest rates have risen in anticipation of a higher-growth, more inflationary environment. That has hurt bond investors this year. We have felt less of an impact as we were significantly underweight to core bonds to protect against just this occurrence. Rates could rise further in the short run leading to greater bond price declines, but they should stay contained unless inflation spikes up and stays higher.
What About Inflation?
Inflation has been at the top of investors’ list of concerns lately. Governments all over the world have passed large fiscal stimulus packages in the wake of the pandemic. There is a lot of potential pent-up spending. Add in an expected economic rebound from the pandemic, and the Fed doing everything it can to stoke a healthy level of inflation, and investors and consumers are understandably worried about maintaining their purchasing power. An inflation spiral would be bad for stocks, bonds, and pocketbooks.
In the coming months, we will in fact see year-over-year inflation increase, most likely to the 3%-plus range. But this is largely due to prices rebounding from the pandemic lows. We want our clients to know that what really matters is meaningful, sustained inflation. The jury will still be out even after the next couple of months as to whether this higher inflation will be transitory or the beginning of a longer-term trend.
Our portfolios tilt toward stocks that will benefit from higher economic growth. Floating-rate loans offer natural inflation protection. And we have diversified into flexible bond strategies that, with their yield advantage and active management flexibility, should outperform core bonds.