November 9, 2020 was a milestone date for both the fight against COVID-19 and for the economy and capital markets.
That was the date that Pfizer announced the stunning news that their rapidly developed vaccine was more than 90% effective in protecting against COVID-19. Within days, other large pharmaceutical companies announced similar extremely positive vaccine news. This was the catalyst that sparked the next surge in stock prices, continuing the strong rally from the pandemic fear lows of March 2020.
Reopening and reflation dynamics
The vaccine news led to a real jump start for the economy, as consumers re-engaged in the economy by going back to work, spending their built-up savings and government transfer payments, buying homes with the aid of extremely low mortgage rates, and investing in the stock market. Businesses also re-engaged by investing in capital projects, looking for acquisition targets, and buying back stock.
This key development also led investors to reposition portfolios to take advantage of the potential “reopening” of the economy, and to protect against the possibility of “reflation” as business returned to normal. Reflation can trigger rising inflation, higher interest rates, strong economic growth, strong earnings, and strengthening cyclicals, value, and small-cap stocks. But recent doubts about the sustainability of the reflation phase – especially in light of the perceived hawkish shift by the Federal Reserve (Fed) and expectations that growth has peaked – has led to the recent underperformance of small-cap stocks, cyclicals, and value stocks, along with lower interest rates.
This change in investor perception has again demonstrated that rather than a single stock market, there are multiple market sectors with different fundamental characteristics.
While the broad S&P 500® index and other developed country indices were up over 12% from November 9, 2020 through the end of the first quarter of 2021, cyclical, value, and small-cap stocks surged even higher, with value-oriented indices up about 19% and small cap-oriented indices up over 30%. Meanwhile bond yields rose by nearly 75 basis points, resulting in market value losses of over 12% for longer maturity treasury bonds. (The S&P 500 is a market-cap-weighted index that represents the average performance of a group of 500 large capitalization stocks.)
Rethinking the reopening and reflation dynamics
Since the end of the first quarter, the “reopening/reflation” theme in the market seems to have come into question, leading to wide disparities in short-term relative performance across market sectors. Since March 31, 2021 through mid-July, large-cap growth stocks (aka mega cap technology) have reasserted their performance leadership, up approximately 12%, while value and small-cap sectors are up only about 5% and 2% respectively.
There is skepticism about the economy’s ability to transition from an expansion being fueled predominantly by massive fiscal and monetary government support to a more durable expansion fueled by organic consumer demand, business investment and stabilizing global trade.
The bond market is reflecting this skepticism. It again has confounded market expectations of rising rates, with long term bond yields falling a surprising 40 basis points since the end of the first quarter. Bond yields have been falling despite reported inflation reports running at double digit annualized rates, a frenzied housing market, and surging commodity prices. It appears that the bond market is “buying” the Fed’s argument that this surge in reported inflation will prove to be transitory and that long-term inflation will eventually settle into the 2% range that the Fed has long tried to achieve.
Markets don’t fear the ‘taper’
The reaction in the bond market is also surprising in light of investor memories over “tapering” – the eventual winding down and ending of the Fed’s long running program of buying large amounts of treasury and mortgage-backed bonds. The Fed has been very careful in addressing this issue. It is fully aware of the “taper tantrum” of 2013 when both bond and stock markets sold off sharply following unexpected comments from then Fed Chair Ben Bernanke about winding down its asset purchase program.
The Fed has made clear that in order to finally get inflation up to its target of 2%, it will be comfortable in seeing inflation “run hot” for a bit before moving more assertively to remove extra liquidity and raise short-term interest rates.
It essentially is now using a framework that is looking at average levels of reported inflation over a longer time frame. The market seems to have confidence in the Fed’s ability to successfully calibrate policy this way in the $22 trillion domestic economy. However, unlike in 2013, the Fed is aided in this new policy approach by the unprecedented level of negative bond yields outside of the U.S.
These negative yields are a manifestation of an extreme excess of global capital relative to investment opportunities. With such negative yields globally, any uptick in yields, as was seen late in 2020, is met by a tsunami of capital looking for any incremental yield, regardless of how insignificant it is relative to inflation.
The first half of the year has been very rewarding for equity investors with solid double digit returns across most sectors of the U.S. equity markets. As a result, stock market valuation, as measured by P/E multiples, remains quite high by historical standards, but less so when taking into consideration historically low interest rates. It still seems premature to adopt a more defensive long-term portfolio position given economic fundamentals, decent corporate earnings growth and uncompelling bond yields.
Relative equity sector performance has been rotating on nearly a monthly basis since the first quarter of this year, with the more cyclical small-cap and value sectors outpacing the broader market for four to six weeks, followed by the more defensive large-cap growth sectors outperforming for the following four to six weeks.
Currently large-cap growth sectors are prevailing in the short-term performance sweepstakes. From a long-term fundamental standpoint, the persistent strength in large-cap growth is justified due to the sector’s superior growth, profitability and return on capital metrics.
As for the more cyclically oriented equity sectors, although the economy is showing some signs of moderating growth as it transitions from government support programs to more durable organic growth, there remains a solid economic foundation to support the small, mid and value sectors as well. In short, trying to anticipate and rapidly adjust portfolios to exploit performance rotation is a fool’s errand in such an environment.
Currently, with the U.S. economy remaining on a solid growth trajectory, interest rates persisting at incredibly low levels relative to current and prospective inflation, and excess investment capital in abundance, a balanced U.S. equity portfolio with sector allocations close to long term strategic targets across growth, value and size dimensions seems appropriate.
International equities, especially emerging market equities, are less compelling relative to domestic equities. Many countries are struggling with new virus variants and have more challenges in returning to economic growth. Heavy handed government action by the Chinese government against key companies and industries is casting a pall over that country’s markets and emerging markets more broadly.
As for bonds, although they will continue to garner support due to the glut of global capital, and accommodative central banks, an underweight exposure remains appropriate given that current yields and expected returns relative to an inflation environment of 2% (at best) are uninspiring.
With most treasury bond yields below 1%, high quality corporate bond yields at 2-3% and even high yield bond yields under 4%, using income alternatives such as floating rate loans, preferred stocks and some niche sectors of the equity market remain compelling to add some incremental yield and diversification to the portfolio.