Mar 30, 2021 FAS Monthly Market Update March 2021
Posted By FAS Team
U.S. GDP growth increased at an annual rate of 4.1% in Q4 2020, according to the second estimate released by the U.S. Department of Commerce. This is a slight uptick from the estimate released in January. Not one month ago the U.S. economy looked to be banging on all cylinders with Congress committing another $1.9T in stimulus spending, manufacturing hitting its highest level since 2018, and continued increases in household wealth and personal income through January. In late February/early March, the Atlanta Fed’s GDPNow tool was projecting 10% GDP growth in Q1 2021 and the New York Fed’s Nowcast tool was projecting 8%+ growth. Both readings have since fallen to mid-single digits due to decelerating economic data such as falls in housing starts, retail sales, and industrial production. After a large spike in January, following the late-2020 stimulus checks, personal consumption is expected to slow, however that could turn around in March and April with yet another round of stimulus checks going out. Despite the slowdown in economic data, the economy is still trending in the right direction and the growth outlook is positive, at least for the intermediate term as more vaccines are distributed, businesses begin to operate at higher capacities, and more people get back to work. The volatility seen since late-February has had more to do with interest rates and the Fed than the health or outlook of the economy. In fact, the growth prospects of the economy can be considered part of the reason for the volatility we’ve seen, which we cover in the next section.
Market Conditions & the “Breakdown” in Tech
After reaching a new all-time high in mid-February the NASDAQ proceeded to pull back to near-correction territory before recovering to finish positive for the month, only to recede further into correction territory. From peak to trough the tech heavy index was down 10.5% by early-March, but probably not for reasons many would have considered. An environment of accelerating growth and accelerating inflation is traditionally a good thing for most stocks, so why has tech underperformed?
There are several reasons for this. First, tech was clearly the primary beneficiary of the pandemic last year due to the lockdowns, business closures and stay at home orders. This caused investors to flood into the sector, inflating valuations, which were already borderline expensive, while sectors like energy and financials were left by the wayside with gas demand falling and interest rates at record lows.
As the economy continues to reopen, the growth prospects for all sectors begin to look attractive – sectors like energy, financials, materials and industrials. Again, an environment of accelerating growth and accelerating inflation is, overall, a good thing for stocks. There just happened to be a lot of stocks (like energy and financials) which looked a lot cheaper relative to tech. It goes without saying that as things reopen, people are going to be driving a lot more which is great for energy. Consumers, finally able to get out of the house, are going to go out and spend money on things – things that need to be produced with equipment that may need to be purchased which is great for materials and industrials.
All of this growth and spending creates a positive outlook for growth in the economy which in turn creates higher inflation expectations – i.e. rising prices. As inflation ticks up, so do interest rates, specifically longer-term rates such as the 10-year treasury, as they are an indication of expected future economic growth. In these environments people are more willing to borrow money or use leverage to invest in homes, businesses and financial assets. In typical supply and demand fashion, the more demand for something there is (money), the higher the price (rates). It is also worth mentioning that higher interest rates are positive for financials, such as banks, who borrow money from investors in the form of deposits and lend that money out to borrowers such as home buyers and business owners. Higher long-term rates, while still paying close to 0% on deposits, is great for bank profit margins, which is ultimately great for bank (financials) stock prices. All of the sectors that lagged through the pandemic are all of a sudden looking a lot “cheaper” relative to tech, hence the relative outperformance. Now enter the Fed.
Much of the growth throughout the last 10+ years has been primarily driven by both fiscal and monetary stimulus, albeit mostly monetary. The Fed lowers interest rates in times of crisis such as during the Global Financial Crisis and Covid-19 and “prints” money through quantitative easing (QE) by injecting liquidity into banks for them to lend out to borrowers at those low rates to kick start the economy. This is great for the economy because it encourages people to go out and spend money). One person’s expenses is another person’s income. When we put this all together we have a healthy, growing economy.
Just as it is the Fed’s job to maximize sustainable employment, its “dual mandate” states that it must also provide price stability, or control inflation. Employment is managed by lowering rates and encouraging people to borrow and spend which ultimately should create jobs. Inflation is somewhat of an afterthought in times of crises since the Fed must do all they can to avoid deflation – falling prices and therefore falling incomes. It is a constant balancing act between keeping unemployment low and keeping inflation positive, but not too positive as that can lead to hyperinflation which could cause a “hard landing” and send the economy right back into a recession.
The problem with this is that there has been no inflation over the last decade and the Fed has done everything it could to avoid deflation. This is why the comments by Fed Chair Jerome Powell in early March may have spooked the markets. After bottoming out in mid-2020, rates have risen to pre-pandemic levels causing concern for the markets who look to the Fed to ensure rates do not rise too quickly. Powell offered very little commentary on actions the Fed would take if rates were to rise too fast. This ultimately caused rates to continue their rise and stocks to fall. It is worth noting that it should really not be the Fed’s job to prop up the stock market by appeasing to it whenever we see bouts of volatility. That being said, if rates do continue to rise too high too fast, their hand may be forced in order to avoid further volatility and potentially a downturn. However, it is important to understand that the overall outlook for the economy is positive so rising rates are not the end of the world. The problem would arise when growth begins to decelerate or contract with inflation still running hot.
Bringing this all back to where we started, interest rates are used in valuing stocks and when the risk free rate which is used for determining the value of a stock or a company ticks higher, it can have an impact on the present value of that company’s growth to the downside, specifically highly leveraged companies with high debt levels. Tech stocks aren’t necessarily falling because of rising interest rates. They just happen to be falling at the same time interest rates are rising, and they are both happening for virtually the same reason, which is improving economic growth. If that growth continues then most prices should follow. It is also important to point out the NASDAQ is still up over 70% over the trailing year, however it would be understandable for those who only recently dove in after not being invested for most of 2020 to be upset about recent events and are quickly finding out that stocks do not, in fact, “only go up.”
Disclosures & Index Definitions
Under style performance boxes, indexes referenced in the equities section for large, mid and small reference the Russell 1000, Russell MidCap and Russell 2000 stock indices, respectively. The Barclays US Government, Barclays Credit and Barclays High Yield fixed income indices refer to Gov’t, Corp, and HY, respectively. Short, Intermediate and Long refer to the time frame of the investments and their positions on the yield curve.
The information and opinions stated in this presentation are not intended to be utilized as an overall guide to investing; nor should they be taken as recommendations to buy, sell or hold any particular investment. This presentation is not an offer to sell or a solicitation of any investment products or other financial product or service, an official confirmation of any transaction, or an official statement of presenter. The opinions and views conveyed are for informational purposes and make no recommendations in regards to how a client’s portfolio should be managed, as that involves inquiring, in depth, of a client’s or prospective client’s risk tolerance, investment objectives, time frame for investing and any other details pertinent to said client’s or prospective client’s financial situation. The presentation may not be suitable to be relied on for accounting, legal or tax advice.
Past performance is not indicative of future returns. Prices and values of investment vehicles will rise and fall as broad market conditions change. Investors’ portfolios may fluctuate, to varying degrees, in tandem with market conditions. Diversification neither guarantees returns nor does it eliminate the risk of a portfolio decreasing in value. Equity securities tend to be more volatile than bond/fixed income products and carry greater risk factors than that of fixed income products. Smaller capitalization equities (i.e. mid and small caps) typically involve more risk than that of larger capitalization stocks. Political, economic, and currency risk are all risks subsumed under the additional risk factors of investments in international securities, to include those in both developed and emerging markets. In addition, political conditions in emerging markets can tend to be more volatile than in those of developed markets.
Investments in bonds will be subject to credit risk, market risk and interest rate risk. Interest rates will have an inverse effect on prices of bonds. Bonds of lower credit ratings, also known as High Yield bonds which hold a rating of less than investment grade (BB+ and below), will have greater risks attached than will those of investment grade bonds and will experience greater volatility.
All dates are as of February 26, 2021 unless stated otherwise.
Presentation prepared by Financial Advisory Service, Inc., an SEC Registered Investment Adviser. Securities offered through FAS Corp., an affiliated insurance agency and broker/dealer.
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The S&P 500 Index is based on the market capitalizations of 500 large companies whose stocks are listed on the NYSE and NASDAQ. This is widely regarded as the single best gauge of large cap US Equities.
The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks, primarily industrials. It is used as a barometer of how shares if the largest US companies are performing.
The NASDAQ is a market capitalization weighted index of the more than 3000 common equities listed on the NASDAQ Stock Exchange. These securities include American Depository Receipts, common stocks, real estate investment trusts, and tracking stocks.
The MSCI EAFE (Europe, Australasia, Far East) Net Index is recognized as the pre-eminent benchmark in the US to measure international equity performance. It comprises the MSCI country indices that represent developed markets outside of North America, Europe, Australia, and the Far East.
The MSCI Emerging Markets Index captures large and mid cap representation across 23 Emerging Markets (EM) countries. With 822 countries, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The Barclays US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS, ABS, and CMBS.
All index information has been gathered from public sources who are assumed to be reliable, although we cannot guarantee the accuracy or completeness of those public sources.