Q1 2021
April 6, 2021
In many ways, the performance of the stock and bond markets this past quarter was predictable. We know the underlying themes driving the near-term: post-pandemic economic growth and low interest rates.
I wrote last quarter about how low interest rates are helping to sustain a premium in stock prices. A couple of times this past quarter, interest rates moved up resulting in a sell-off in stocks. Over the whole quarter, however, stocks produced single digit gains. Investors continue to expect strong earnings growth this year, which will continue to drive stock prices.
Within the stock market, the types of stocks that are working is clearly shifting. For the past several years, large cap growth stocks have significantly outperformed all other segments of the market. Since late last year, we have seen mid/small cap and more cyclical stocks drive the market’s advance.
That is not particularly surprising as the underlying theme for 2021 is economic recovery, so we should expect better earnings growth from cyclical stocks. The outperformance of mid/small stocks and cyclicals is typical in the early part of a recovery.
What will be important to watch is the lingering effects of the pandemic on this recovery. The data shows tremendous pent-up consumer spending capacity has been accumulated this past year. The U.S. Personal Saving Rate is typically well below 10%, but during 2020 the rate spiked to almost 35% in April and has been above 10% every month since shutdowns were mandated.
If the U.S. consumer returns to past behavior as things open, we should see a significant spike in spending. I believe a spike in spending is already priced into the stock market’s expectations. The more important question will be how long will this surge in activity persist? This is a more difficult question because we are not certain of the long-term damage that has been caused by the shutdowns.
I have worried about small businesses. A casual bit of unscientific research found me wandering through the shopping district of downtown Minneapolis (known locally as: “the skyway”). It was a rather disheartening venture. Although businesses with national footprints were open and operating (e.g., Starbucks, Target, Wells Fargo, etc.), most of the locally owned stores were closed with the inventory stripped from the shelves. “For Lease” signs often replaced the previous occupant’s sign.
Now as an investor in publicly traded stocks, I might view this as good news. We don’t own the stocks of small locally owned companies, we own the interests in large companies with national (often international) footprints. If we emerge from the shutdowns with fewer local businesses, spending will be concentrated in these larger stores and their revenues and earnings will be even better.
This is one of the themes that has emerged within the stock market, and one reason why the stocks of some national retailers have been acting quite well.
The problem with this as a theme for the market is it ignores the impact of shuttered businesses on overall employment. Small business accounts for a significant portion of the jobs in the U.S. economy, to sustain decent economic growth, people have to be employed.
How this plays out over the next 12 to 24 months bears watching.
The other risk to the market that I see is interest rates. So long as interest rates remain low, investors will put a premium on stocks. Many investors are comfortable betting that rates will remain low because the Federal Reserve has stated they will not raise rates anytime soon. I made the comment last quarter that investors should not “fight the Fed”. In other words, if the Fed wants rates to be low, we should expect them to remain low.
But we need to remember the level of interest rates are not always fully within the control of the Federal Reserve. The Fed exercises far more influence in periods when inflation is benign. Should inflation start to spike, their control over low interest rates will diminish rapidly.
I mentioned earlier that over this past quarter, stock prices came under pressure a few times as interest rates started moving up. The reason interest rates moved has to do with the market anticipating higher inflation.
At the heart of this concern are the massive spending packages being passed by Congress. Few of us would argue with spending money to help those impacted by the pandemic. What has become a concern is the size of spending packages as we are on the brink of a significant recovery. Basic economic theory would predict that adding government stimulus to an already strong economy would be highly inflationary. That is what concerns the market.
In reality, only a small portion of these packages are going to direct payments to those impacted by the pandemic. Most of the spending is earmarked for projects unrelated to the pandemic and most of the money is spent over time. In a rather odd way, these facts may mitigate some of the inflationary impacts of the stimulus spending.
It appears the next hurdle for the market will be proposals to increase income taxes. I doubt tax increases will undermine the initial phase of the post-pandemic recovery. But increasing taxes will add another uncertainty to the pace of recovery after the initial surge. This too will bear watching.
As we sit here today, we expect the strong anticipated economic recovery to support the stock market. It may be that a year of lost economic activity will translate into a sustained period of strong worldwide growth. It could very well be that our concerns about employment, inflation, and tax hikes are mitigated by growth. At this juncture, it’s impossible to assess. We certainly hope for the best.
We hope you have a happy and healthy Spring!
Mark Hoonsbeen, CFA
Principal