Market Commentary - April 2021

Monthly Update

The stock market continued its impressive year to date rally in April as the S&P 500 rose 5.2% and extended its winning streak to three straight months[1]. The NASDAQ rose by a similar amount and the small cap Russell 2000 was higher for the 7^th straight month, although by only 2.1%[2]. Optimism about the successful vaccine roll out and the strong economic recovery we have on our hands were the main catalysts. At the same time the Federal Reserve still has their monetary pedal to the metal.

Also helping equity sentiment was the pullback in market driven interest rates after the sharp rise seen earlier this year. The 10 yr Treasury yield finished the month at 1.63%, off its high of 1.78% in March[3]. These levels still remain sharply higher for the year, as the December 31^st close was 0.92%[4]. The market has essentially raised intermediate term rates this year in response to quicker economic growth and rising inflationary pressures.

An impressive earnings season, where about 85% of companies reporting exceeded earnings estimates, did not actually help stocks (about 70-75% is considered normal)[5]. As visibility in business in Q1 still was somewhat limited, I take these earnings estimates with a grain of salt. The reason for the lackluster response to earnings is twofold. One being that it was already priced in. Two, for some businesses, there is a question of sustainability.

With respect to the economy, government transfer payments from the Trump signed bill in December 2020, and the Biden one in March 2021, have created an enormous amount of savings for those recipients and has more than offset any lost income from their jobs. In fact, for some receiving enhanced unemployment benefits, they are receiving more than what they were earning in their previous jobs. These added benefits expire in September. In April, the NY Fed released the results of a survey they did on how people are using their government checks. Of those who received them in January, 26% of it on average was spent or planned to be spent, 37% was saved, and the balance used to pay down debt.

On the vaccine front, the CDC says that 44% of the US population have had at least one dose, and 32% are fully vaccinated as of this writing. These are great numbers to see, with success only exceeded by Israel and the UK in terms of their stats. The rest of Europe finally seems to have turned the corner with its vaccine rollout too. Interestingly, in Asia, where they contained Covid the best, they have lagged in the vaccine adoption. India is having a massive 2^nd wave that has tragically overwhelmed their healthcare system. The case is unfortunately similar in Brazil. So, there is a lot to be optimistic on the Covid front, but it is becoming apparent that this is something we’re going to have to live with for a long time.

US Treasuries 

As stated, stocks took their cue in part from the rally in Treasury prices and drop in yields. It had been the sharp rise prior which caused a pause in parts of the stock market, particularly the most overvalued parts of it. Along with the economic recovery, the US economy should fully recapture what was lost in 2020 on a real basis in Q2. Inflationary pressures continue to build and are becoming more and more part of the market’s focus.

Inflation is building in four main parts of the economy and is spilling over into others. Number one, commodity prices have been roaring higher. The CRB raw industrials index, which includes a variety of different inputs, stands at the highest level since August 2011. The CRB food price index is at a level last seen in September 2011. Number two, supply chains have been badly strained. Lead times are rising sharply and there are many shortages of key parts, particularly semiconductors. This then leads to bottlenecks, and thus, higher prices. Number three, the cost of transportation via ship, truck, rail and air are seeing also sharp increases. Keep in mind that everything that gets produced ends up on at least one of these modes of transport. Number four, according to S&P CoreLogic, home prices are rising at an annualized pace of 12%. While home prices are not directly included in both the CPI and PCE inflation gauges, imputed rent is. Rent prices will follow the direction of home prices. What might be another inflation pressure in coming quarters is rising labor costs, which is in response to the tightening labor market, where many companies are finding it more difficult filling job openings.

Looking at the Treasury Inflation Protected Securities (TIPS) market, we can gauge the implied inflation rates that markets expect for the coming years. Also called the “inflation breakeven”, the market currently believes that inflation for the next ten years will average 2.42% as of this writing, up 4 bps from the March close and up from 1.99% at the end of 2021[6]. From a shorter-term perspective, the three year inflation breakeven has risen to 2.72% from 2.07% at year end, and vs 2.60% at the end of March[7]. As these levels are well above nominal interest rates, it means that real rates are deeply negative.

The rise in market driven rates is not just a US thing, as growth hopes and rising inflation is also a global phenomenon. The 10 yr German bund yield is at the least negative since March 2020 at 0.20%[8]. This compares with 0.29% at the March close, and vs 0.57% at year-end 2020[9]. There is chatter within the ECB that the June meeting will include a deeper discussion on when to start the taper of its Pandemic Emergency Purchase Program, which is just more quantitative easing (QE) on top of their already existing program.

The Federal Reserve

The Fed met a few weeks ago and chose to not alter its current monetary policy at all, both in terms of QE and rates. Rates will stay at zero for a while longer, but I believe the pressure on them to begin the taper process of QE is only going to intensify. In fact, Dallas Fed President Robert Kaplan, a nonvoting member this year, recently expressed his desire to begin the taper process soon.

Q1 GDP in the US grew by 6.4%, the Atlanta Fed estimates growth will be 13.2% in Q2[10]. This robust level of growth egged on by mass inoculation, more reopenings, business life returning to normal and aggressive government spending. I believe the Fed is way overstaying its welcome with its emergency type easing. They are driving monetary policy 200 mph in a 55 mph speed zone, and the roads are getting icier in terms of overheating the economy, along with higher inflation.

Stocks

The US equity market, as measured by the S&P 500, has already put in a good year in just four months. I’ve stated the factors, but valuations, in turn, reflect a lot of good news. The question for the rest of the year then is, “to what extent do rates rise further?” Will the Fed, at some point, begin the actual taper of QE, both could negatively impact valuations. I said in January that it was going to be easy to predict the trajectory of economic growth and earnings in 2021 with the vaccine being rolled out. What is more difficult is figuring out what the right P/E multiple should be paid on this if higher rates are the result.

With respect to earnings, there will be a tug of war between good top line growth, but there will also be margin pressures due to the cost increases I’ve talked about. Those companies that have pricing power will certainly absorb the margin hit better than those that don’t. The stock prices of each will reflect that, for better or for worse.

Washington DC

Fresh off the December spending bill of $900 Billion, the Biden administration, along with the Democrats in Congress, passed another one valued at $1.9 Trillion in March[11]. Not to be stopped, this was followed by a plan to spend another $4 Trillion, broken down between pure infrastructure for airports, bridges, roads, water, and broadband in one piece, and spending on healthcare, childcare, and other related things in the other. Along with this are proposed higher taxes on corporations and individuals, in addition to a possibly higher capital gains tax rate. With the Democratic control of Congress very tenuous, it is unclear what will eventually be passed. We have no doubt that spending will increase sharply again and that taxes will go higher, but we are uncertain to what degree. The spending will be spread out over 5-10 years, while the taxes will happen immediately. The drag of the latter will more than offset the pace of the former in terms of its economic impact in 2021 and 2022. We will be watching closely for both economic and market impacts.

Conclusion 

While all the major indices are higher this year, the stock market has gotten very rotational, where some groups do well on one day and others on the next. The direction of the 10 yr yield has been a key factor in dictating this either/or market, and I would expect that to continue to be the case this year. As I said last month, tell me where rates go from here and I will tell you where the different parts of the markets go. That said, overall, I do expect higher rates as the year progresses, which should result in volatile times for stocks because of their high valuations.

Either way, whatever the outcomes will be, it is vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will be a continued choppy time for the economy and markets. Please do not hesitate to reach out at any time with questions or for any discussion on these matters.

Disclaimer