Q1 Market Commentary: Throw the Confetti!
At the end of the quarter, investors were able to celebrate robust returns from riskier asset classes and continued commitment from policymakers to provide extraordinary accommodation.
Another reason for the celebratory mood is the result of the great work from vaccine developers and distributors as more than 169 million Americans have received at least one dose of the COVID-19 vaccine.
These developments overshadowed the bear market in longer-duration bonds and a few high-profile hedge fund blow ups.
Inflation remains the key to decoding how long this environment of unsustainable policy support can last – as long as inflation remains contained, investors may continue to throw the confetti.
The quarter was filled with so many colorful events that it made the first three months of 2021 feel like an entire year. In the end, investors had much to celebrate – equity returns were decidedly positive, and both fiscal and monetary policymakers reiterated their extraordinary accommodative stances. An even bigger reason to throw confetti has been the continued great work of healthcare professionals, essential workers, and vaccine developers. To date, over 109 million Americans have received at least one dose of the COVID-19 vaccine which is a remarkable feat given the virus hit the U.S. just over one year ago.
Although as the S&P 500 Index was up 6% and other risk assets such as commodities were up nearly 7%, the bond market was unusually weak throughout the first quarter of 2021. The BarCap Aggregate Bond Index lost 3%, posting its worst quarterly loss since the third quarter of 1981, when it lost 4%. To put this return into perspective, there have only been three quarters in its history, all in 1980 and 1981, that the index has lost more 3%. During the quarter, the 10-Year Treasury yield increased to a high of 1.75%. While the move seems insignificant in absolute terms, the relative increase is one of the most drastic in history and has brought the long end of the Treasury market, as proxied by the Bloomberg U.S. Long Treasury Index, into bear market territory (declining by over 20% from peak prices last year). The move in rates is not that surprising given the recent confluence of factors: multi-trillion-dollar stimulus and the vaccine rollout jump-starting growth as well as the Federal Reserve’s formal notice to markets that they are willing to tolerate higher inflation. That said, the magnitude and swiftness of the recent move is still historically unrivaled.
In addition to COVID-19 vaccine developments and the Federal Reserve’s willingness to err on the side of higher inflation, the unwind of a program modification enacted during the depths of the crisis, the Supplementary Leverage Ratio (“SLR”), may have also contributed to higher interest rates. An alteration to the SLR was implemented on May 15, 2020 and was designed to ease Treasury market strains and promote lending to households and businesses. The adjustment allowed banks flexibility in what assets they could hold to meet regulatory requirements. More specifically, the Federal Reserve allowed banks to exclude Treasuries and cash from their capital requirement calculation. In the past several weeks, Senators Elizabeth Warren and Sherrod Brown made their views public on why the modified SLR should be allowed to expire. On March 19, the Federal Reserve announced it would let the modified SLR expire on March 31.
From a fiscal and monetary policy perspective, there were a couple developments that were cause for investor celebration. First, fiscal policy makers passed the American Rescue Plan Act of 2021. This $1.9 trillion spending bill included $411 billion in direct payments to individuals, which resulted in $1,400 being sent to individual taxpayers earning up to $75,000 ($2,800 for married couples earning up to $150,000), plus an additional $1,400 per qualified child. The payments phase out for incomes up to $80,000 ($160,000 for married couples).
On the monetary policy side, the Federal Reserve did not make any new announcements, but the fact that they maintained their stance and reiterated they would do so for the foreseeable future, was noteworthy. In their March meeting, the Federal Open Market Committee (FOMC) conveyed, through its dot plot projections, that it would likely keep its federal funds rate at zero through 2023. Furthermore, the committee reiterated its stance of conducting $120 billion of bond purchases per month, a pace that was never reached heading into or out of the credit crisis of 2008-09. The FOMC also released its “Summary of Economic Projections” which included its participants’ expectations that the federal funds rate would remain at 0% through at least 2022. On March 19, the Wall Street journal published an article written by Jerome Powell in which he wrote, “But the recovery is far from complete, so at the Fed we will continue to provide the economy with the support that is needs for as long as it takes.” That support continues to result in vast sums of money being pumped into capital markets and the economy.
There were several other events that occurred during the quarter that reveal the unintended consequences of such abundant liquidity. In January, several so-called “meme stocks” sparked a revolution of sorts. The top performing of these was short-squeezed GameStop, which jumped over 1,000% as part of a short squeeze in which traders launched a coordinated buying raid on the stocks of companies that were contending with an unusual amount of short-selling (the percentage of the company’s total market capitalization that has been sold short). These raids in turn overwhelmed the supply of shares available to buy, leading to rapid price increases. Melvin Capital, a $12 billion hedge fund, came under liquidation pressure due to the meteoric rise of stocks like GameStop. The fund was down 53% in January due to their short exposure (attempting to profit from a decline in the stock price) and required a bailout from high profile investors such as Steven A. Cohen and Citadel.
Also at the center of the melee was the free stock trading app, Robinhood. As a self-proclaimed champion for the small and first-time investor, the company came under scrutiny for the way it handled its customers’ ability to trade stocks at the epicenter of Melvin’s malaise, along with its hundreds of millions of dollars it generates from selling trade order flow to market makers. In the aftermath of the market dysfunction and Congressional hearings on the subject, Robinhood reassessed the animated celebrations on its app, ultimately deciding to remove the digital confetti which pops after users make their first trade.
Late in the quarter, Archegos Capital suffered tens of billions in losses in media stocks such as ViacomCBS, Discovery and Tencent after it was discovered the firm was engaged in highly leveraged speculative bets on these stocks. The firm was able to gear up its exposure to multiples of its actual capital base using over-the-counter synthetic stock positions, which is why the unwind caught the market off guard. Some of those hit hardest in the unravelling were Archegos’ counterparties, Nomura and Credit Suisse. Nomura’s stock price endured its largest daily loss in history after the estimated $2 billion in losses, as a result of exposure to Archegos, was disclosed. Credit Suisse disclosed a loss of $4.7 billion and announcement a dividend cut as a result.
Another seemingly unrelated issue hit investors in the $1.8 billion Infinity Q Capital Management mutual fund. The investment firm discovered that a portfolio manager had access to and altered the third-party valuation (and pricing) of swap contracts. The fund has suspended redemptions indefinitely while it unravels the issue.
While all of these events seem isolated and may lack the scale required to derail a global market recovery, there is a common thread: a trend to increasing levels of risk-seeking behavior and a reduced focus on risk management.
It is unlikely that the Federal Reserve is overly concerned by the rise in long-term interest rates to date, especially given the indifference to the move implied by the S&P 500 pushing through 4,000 to new all-time highs in early April. That said, the Fed may have already begun to use its various tools to slow the pace of the rise. On March 17, the FOMC kept in place the $120 billion per month of purchases of Treasury and agency mortgage-backed securities. This consistent source of buying may prove to be a meaningful factor in the shape of the yield curve in the quarters ahead.
Of the $120 billion in fixed income securities being purchased by the Fed every month, $80 billion are U.S. Treasuries. Considering that the U.S. Treasury issued approximately $400 billion in bonds during the first quarter, the Fed effectively monetized sixty percent of total issuance. In the second quarter, the Treasury expects issuance to be just $95 billion, implying effective monetization of roughly three times the amount to be issued. While issuance is generally low in the second quarter because of federal tax receipts, it remains especially low in 2021 because the Treasury began the year with a colossal $1.7 trillion in cash. As of the end of March, the Treasury had a cash balance of $1.1 trillion.
Value stocks outperformed growth stocks during the quarter while smaller companies outperformed larger companies. The Russell 2000 Value Index, a measure of small cap value stocks, outpaced all other equity asset classes with a gain of 21% during the first quarter. This followed a 33% gain in the fourth quarter of last year. The Russell 1000 Value Index, a measure of large cap value stocks, was higher by 11% during the quarter (they were up 16% in the final quarter of 2020). The Russell 1000 Growth and 2000 Growth indices were up 1% and 5%, respectively. Energy was the best performing sector for the quarter, up 31%, while the technology sector rose just 2%. This performance served to reverse a portion of the 77% spread between the energy and technology sectors last year. Equities outside the U.S. once again trailed during the quarter. Developed market countries, as measured by the MSCI EAFE Index, returned 4% while emerging market stocks, as measured by the MSCI Emerging Markets Index, were higher by about 2%.
Investor optimism has also extended to their expectations for corporate earnings. Estimates for S&P 500 operating earnings in 2021 are currently $172 per share, which would represent a 41% increase from 2020. It would also be a new high in earnings, eclipsing the $157 per share mark set in 2019. The S&P 500 currently trades at a one-year forward price-to-earnings ratio of 22 times, not far from the Tech Bubble high of 26 times.
Municipal bonds, as measured by the Bloomberg Barclays Municipal 1-10 Year Bond Index, fared much better than investment-grade taxable bonds during the quarter as they lost less than 0.5%. The Bloomberg Barclays High Yield Index was able to absorb the rise in interest rates and post a gain of 0.8%.
At the end of the quarter, the Biden Administration announced an infrastructure plan, the American Jobs Plan, and the Made in America Tax Plan. The infrastructure spending bill seeks to invest $2 trillion over the next decade, with 1% of GDP per year invested in infrastructure over the next eight years. The tax plan is designed to fund a portion of the investment by increasing the corporate tax rate to 28% and increasing the minimum tax on U.S. companies to 21% to avoid multi-national U.S. companies receiving an exemption on foreign asset returns. It is clear policymakers want nothing more than to keep accommodation at unsustainable levels for as long as they can. A key to this is the Federal Reserve’s ability to continue to monetize these enormous spending bills. Currently, capital markets appear willing to tolerate this path as risky assets and the U.S. dollar are relatively stable. Interest rates, too, are well-contained relative to history, even taking into account the recent rise.
From our viewpoint, inflation will continue to be the most important metric to watch as to when the confetti will stop getting thrown and monetary and fiscal policy accommodation may need to be toned down. In the coming months, data on inflation will be hard to gauge as it will not only reflect substantial recent stimulus but also the low base effects relative to one year ago due to COVID-19 hitting the U.S. Even more important than the data itself will be investors’ reaction to it. As long as inflation remains contained, policymakers can continue to spend and monetize, and investors may be able to continue to throw the confetti.
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