Broker Check

Oarsman Outlook: April 2021

April 14, 2021

As investors anticipated the strongest economy in a half-century, the January-March period saw a re-acceleration of the year-old financial-market rally. Domestic equity benchmarks jumped between 6% and 13%, with small-company stocks leading by a wide margin. Non-U.S. markets lagged, but both developed- and emerging-market categories notched solid gains. Industrial commodity prices leapt: copper rose 13%; oil, more than 20%; gold, a "safe-haven" not much in demand, fell nearly 10%. Bond yields surged: the 10-year Treasury finished at 1.75%, compared with 0.92% at yearend, resulting in flat or negative returns from most fixed-income investments.

Among U.S. large-company stocks, those in economy-sensitive sectors (Basic Materials, Energy, Financials, Industrials) generally produced the strongest results, while consistent-growth categories (Consumer Staples, Health Care, Technology, Utilities) mostly lagged. 'Value' stocks again outpaced their 'growth' counterparts by wide margins in both large- and small-cap universes.


Twenty twenty-one began much as 2020 ended, with a public-health disaster and weakened economy juxtaposed against buoyant financial markets whose participants looked beyond current gloom to a brighter post-pandemic future. Though rising yields depressed bond prices, stocks continued to soar: the S&P 500 Index's cumulative climb of more than +75% from its March 2020 nadir was the biggest twelve-month advance since the 1930s - and the third largest ever.

Though the year began amidst a dreadful 'third wave,' U.S. pandemic-related news steadily improved as the January-March period progressed. The hopeful mood was buttressed by the eagerly anticipated vaccine rollout, where the United States initially performed well compared to most other major countries. Optimism was tempered by rising infection rates, worries about new, more infectious variants, and renewed lockdown restrictions across much of the globe - malevolent trends that loomed over the U.S. as the quarter ended.

Economic data released during the quarter were mixed, driven by geographically divergent public-health situations and varying impacts of COVID-related restrictions on different industries. Boosted by two rounds of Federal relief funds, the U.S. economy continued to grow at about the same pace as late-2020's healthy-but-not-torrid +4.1% (annualized). Manufacturing, residential real estate, and consumer confidence/spending showed notable strength, while the large services sector (home to restaurants, hotels, airlines, etc.) remained unsurprisingly weaker. Both February and March jobs reports were blow-out upside surprises, though weekly claims for unemployment benefits remained elevated; the official unemployment rate of 6.0% (compared with 3.5% prior to the onset of the pandemic) probably understated lingering weakness in the labor market. Overseas, European economies and Japan were hamstrung by virulently resurgent virus and related lockdowns, with growth hovering near zero. China, meanwhile, continued to steam ahead, benefiting from a contained pandemic, previous policy stimulus, and robust global demand for many of its manufactured exports.

Macroeconomic policy remained extremely accommodative. Major central banks continued to hold short-term interest rates near or below zero and maintained large-scale purchases of longer-term bonds and other assets. In the U.S., Federal Reserve officials took pains to convey that they were (still) not even 'thinking about thinking about' hiking rates, while emphasizing their focus on ameliorating the deep economic damage caused by the pandemic. Meanwhile, Congress pushed through the Biden administration's American Rescue Plan - a $1.9 trillion emergency-spending program aimed at shoring up the most battered segments of the economy. As the quarter ended, market participants began to handicap the likelihood of additional government spending programs.

Rebounding growth and the prospect of 'fiscal policy on steroids' ignited a dramatic rise in bond yields, resulting in the worst three-month shellacking in more than 40 years for long-dated U.S. Treasurys, which provided a total return of -13%. Rising 'real' interest rates were accompanied by a jump in expected future inflation, as investors eyed rising commodity prices, supply-chain bottlenecks, and renewed pricing power in a growing array or 're-opening' industries.

Within global equity markets, a distinct 'rotation' that began in September 2020 remained prominent. This shift has seen mega-cap stocks in the technology, communications and e-commerce sectors (among others) - regarded as relative beneficiaries of the pandemic-induced 'Work From Home' economy of 2020 - lag badly behind those expected to thrive in the re-opening, 'Back To Normal' environment of the future. The trend has favored lower-multiple (i.e., value), smaller-capitalization, and economy-sensitive shares. (Because favored categories are relatively more abundant in many overseas stock markets, non-U.S. investments have also benefited, though a correction among higher-growth Chinese equities and a modest rise in the foreign-exchange value of the U.S. currency were offsets during the January-March period.) The below graphic contrasts the performance of various investment categories in the periods before and since the beginning of what Bespoke Investment Group has called the 'Big Shift.'

The January-March period featured several eyebrow-raising developments suggesting rising investor complacency and market froth. Crypto-currencies (e.g., Bitcoin) surged to all-time highs while 'non-fungible tokens' (don't ask) sold for millions. Market participants were captivated by the absurd gyrations of so-called 'meme stocks' (e.g., GameStop, AMC Theaters, Koss Corp.) and the faddish popularity of SPACs (special-purpose acquisition companies; also known as 'blank check companies') - shell companies floated on stock exchanges in the hopes of one day merging with a sure-to-be-spectacular (but as-yet-unidentified) non-public start-up. The quarter also saw an explosion of Wall Street-engineered merger & acquisition deals, the value of which eclipsed levels seen at the early-2000 peak of the dot-com boom. Finally, the late-March implosion of highly levered, derivative-based stock-market bets at the Archegos family-office recalled 1998's Long-Term Capital Management debacle. As summed up by the Wall Street Journal: "Investors big and small seemed to show no fear of risk-taking as 2021 began."

Earnings reported during the period by S&P 500 companies, mostly covering the final three months of 2020, came in about 6% below the corresponding figure from 2019 - but were broadly better than expected. The next few quarterly figures will be flattered by comparison with the worst of the pandemic's impact: the first quarter and full-year are both expected to be almost 40% higher than 2020 levels; the full-year estimate would represent a 15% improvement versus 2019. At a price level of 4000, the S&P 500 Index trades at 23 and 20 times the 2021 and 2022 estimates, compared to a historical norm around 14 to 16 times.

What's Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

  1. Dividend Income (for three months this is the annual yield divided by four)
  2. +/- Change in Earnings per Share* (average for S&P 500 companies)
  3. +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

* based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to produce the +6.2% S&P 500 total return?

First Quarter (January-March) 2021
Dividend Income+0.4%+6.2%
+ Change in Earnings+8.8%
+ Change in Valuation-3.0%
= Total Return+6.2%

Our read: An outsize improvement in year-ahead earnings provided much-needed support for high stock-market valuation; this trend should continue through 2021.


On the surface, the outlook for the next year or so seems almost beyond debate: the spread of vaccination across the globe will unleash a titanic rebound in economic growth, which will redound to the benefit of publicly traded companies and their shareholders. But, as strategists at PIMCO recently pointed out, the global recession caused by the pandemic was almost without precedent, driven by lockdowns and voluntary social distancing rather than underlying economic and financial strains; accordingly, substantial uncertainty remains regarding the path of recovery.

In its second year, the COVID pandemic continues to exert great influence on the global economy and financial markets. Widespread vaccinations will allow something approximating normal life to resume as early as midyear in the U.S.; other key players in the global economy will lag at varying intervals, with Japan and Europe trailed by nearly all major developing nations. (Paradoxically, China and other Asian nations that were especially successful in containing the virus have been among the slowest to deploy vaccines.) The virus's late-winter resurgence in Europe and elsewhere retains unquantified potential to disrupt recovery in the months ahead.

Despite lingering pandemic-related uncertainties, prospects for near-term economic growth are improving from a healthy base. In the U.S., the combination of aggressively expansionary fiscal policy and a Fed actively encouraging higher inflation in pursuit of full employment sets the stage for a banner year - likely the best since the mid-1980s. The Wall Street consensus calls for full-year GDP growth above 5%, and there is no shortage of calls beginning with 6s and even 7s. Although policy support is now being withdrawn, the Chinese economy, too, is likely to be very strong, with full-year growth exceeding comfortably the undemanding official target ('above 6%'). Meanwhile, Japan and Europe will be relative laggards, due to less audacious policy stances, persistent COVID-related restrictions and sluggish vaccination programs, though growth (probably between 3% and 4%) is nevertheless likely to exceed long-term averages. Many emerging-market economies will struggle to vaccinate meaningful fractions of their populations, but these too will pick up steam as the year progresses (and likely accelerate in 2022). In all, the IMF has pegged global growth at +5.5% (a figure likely to be revised higher), which would be the strongest in some 50 years.

The prospect of super-strong growth has inevitably sparked concerns of economic 'overheating' and a surge in inflation that would elicit a harsh central-bank response, crush the recovery and derail financial markets. To wit: a recent Bank of America survey indicated, for the first time in its nine-year history, that inflation was institutional investors' number-one worry.

Reported inflation over the reminder of 2021 will mechanically rise sharply as year-ago depressed stats drop out of current data. Some additional upward pressure on prices is to be expected given robust demand and production/distribution bottlenecks. But a one-time rise in prices - especially following a decade of stubbornly below-target gains - does not pose the same threat as entrenched inflation, which needs above all else persistently strong wage growth to get started. That seems unlikely given a U.S. economy still some nine million jobs short of its early 2020 level. And America is an overachiever: the 'hole' left by the COVID recession is sufficiently deep in many countries that even two-plus years of above-average growth (in 2021-2022) will leave economies below pre-pandemic paths - suggesting 'slack resources' (inflation's nemesis) will remain abundant on a global basis for some time.

Meanwhile, the secular forces (globalization, technology, demographics, excess savings/ deficient investment) that have kept inflation at bay the past three decades are evolving only gradually and in disparate directions. This is not to say that inflation couldn't someday become a problem - just that is unlikely to happen soon. As Fed Chair Jay Powell recently put it: "Inflation dynamics do change…, but they don't change on a dime." That sanguine attitude - and Fed officials' ability (or otherwise) to convince market participants of its continuing wisdom and sincerity - will be a key financial-market dynamic in the months ahead.

A final note on inflation/bond-market dynamics: as interest rates rise, U.S. bonds quickly become highly attractive to yield-starved global investors. According to JP Morgan Asset management, 10-year U.S. government bonds at 1.7% yield more than 69% of all bonds in the Barclays Global Aggregate Index, vanishingly few issuers of which match the strength and credibility of the U.S. Treasury. And even if hedge fund honcho Ray Dalio thinks bonds at current yields are "stupid," regulators and accountants will continue to require global banks, insurers and pension funds to keep buying them in enormous quantities.

Investors must also grapple in coming months with whether the seven-month-old market 'rotation' still has legs or has mostly run its course. Conditions conducive to smaller, lower-valued, more-cyclical shares — strong growth, improving pricing power, higher interest rates - all seem set to remain in place for some time. But markets are (sometimes notoriously) forward-looking. And it seems plausible that, regarding prospects for the U.S. economy, we are not far from "peak enthusiasm." If so, the biggest relative gains may have been made, and the period ahead might see a more balanced performance across both cyclical and less economy-sensitive market sectors. As for non-U.S. investments, shifting perceptions of relative growth prospects and interest rates have recently boosted the value of the dollar, posing a headwind for American investors (and heavily-indebted emerging-market countries). As 2021 progresses, this trend could begin to reverse, as vaccination and economic re-opening spread across the globe. It may therefore be prudent to maintain substantial portfolio exposure to non-U.S. equities, whose relatively low valuations still represent a compelling opportunity for long-term investors.

The buoyant markets and ebullient mood of early 2021 remind us of Warren Buffett's nostrum that it is often wise to be cautious when others are greedy (as well as vice versa). A combination of burgeoning complacency, high valuations and rising bond yields - legacies of the heady market advance of the past twelve months - is set to be powerfully countered by a (widely anticipated) earnings surge generated by the strongest economic growth many investors have ever seen. That contest will be the main event for the reminder of the year - and we remain focused on the challenge of positioning your investments for success regardless of its outcome.

Please call or email any time with questions or comments regarding our management of your investments. We hope you enjoy a spectacular spring.