The first quarter of 2021 was marked by several macro- and micro-economic surprises that resulted in increased market volatility compared to the fourth quarter of 2020. However, additional economic stimulus combined with accelerating COVID-19 vaccine distribution and a decline in coronavirus cases helped stocks start the new year with solid gains.
The first surprise of 2021 came on January 5th when both Democratic candidates won Georgia Senate seats in the runoff election, giving the Democratic party a majority in the Senate and control of Congress and the presidency. The very next day, during confirmation of the November 2020 presidential election results, protestors stormed the U.S. Capitol, causing a temporary delay to the election certification and marking a historically tragic day in the U.S. democratic process. But after that short delay, Joe Biden was certified as the winner of the 2020 election and became president-elect of the United States. Both the surprise election results and the incident at the Capitol caused a volatile start to the new year.
In late January, after two weeks of relative calm, market volatility returned, this time driven by a historic short squeeze in videogame retailer GameStop (GME). The disorderly trading in GameStop and select other stocks caused broader market volatility, primarily due to fears of losses inflicted on large hedge funds because of the various short squeezes. Those factors combined to pressure stocks and the S&P 500 finished January with a modest loss.
But concerns of widespread losses due to GameStop trading ultimately proved unfounded, and the volatility linked to the GameStop saga dissipated in early February. And as trading returned to normal, investors began to focus on macro-economic positives. First, the Democratic controlled government immediately began steps to pass another massive economic stimulus bill, and that helped stocks rally in early February. Second, vaccine distribution throughout the U.S. meaningfully accelerated in February. That increased distribution combined with the authorization of a single-dose Johnson & Johnson COVID-19 vaccine helped investors embrace the idea that the end of the pandemic was now possibly just months away, and that sentiment helped stocks rally further. Finally, COVID-19 cases began to decline rapidly in the U.S., leading to economic re-openings in several states. The S&P 500 recouped all of January’s losses and ended February slightly positive for the year.
Equity markets continued to rally in early March as investors began to price in a looming economic recovery following the passage of the massive $1.9 trillion economic stimulus bill, which President Biden signed on March 11th. That new stimulus, combined with COVID-19 vaccine distribution reaching 2.5 million doses/day, resulted in growing expectations for a full economic reopening and recovery in the coming months. But expectations for an acceleration in economic growth also pushed Treasury yields higher during the month of March. The 10-year Treasury yield surged to fresh one-year highs and the rapid rise in bond yields weighed on stocks periodically throughout March, as higher borrowing costs could become a future headwind on economic growth. But while the risk of high yields must be monitored going forward, it was not enough to offset the reality of historic economic stimulus and improvement in the pandemic, and stocks drifted higher to finish the quarter with solid gains.
The first quarter of 2021 at times reminded investors of the volatility and unpredictable nature of markets that we all witnessed in 2020; however, just like markets proved resilient last year, stocks overcame multiple surprises during the first quarter to provide another positive quarterly return.
1st Quarter Performance Review
Expectations of a post-COVID-19 economic recovery drove market performance in the first quarter, as the Dow Jones Industrial Average outperformed both the S&P 500 and the Nasdaq 100 due to the underperformance of technology shares.
By market capitalization, small-cap stocks, which are historically more sensitive to changes in economic growth, outperformed large-cap stocks as COVID-19 cases declined and numerous states partially or fully reopened their economies, leading investors to expect a broad acceleration in future economic activity.
From an investment style standpoint, value handily outperformed growth for a second consecutive quarter. The substantial outperformance by value stocks once again underscored increasing investor optimism for an economic rebound in the coming months.
On a sector level, all 11 S&P 500 sectors finished the first quarter with positive returns. Cyclical sectors, including energy, financials, industrials, and materials led markets higher for the second straight quarter. As mentioned, expectations of an acceleration in future economic growth (again, mainly a product of stimulus and COVID-19 vaccine distribution), combined with higher bond yields and fears of potentially rising inflation, drove the cyclical sector outperformance in the first quarter.
One of the biggest sector laggards in the first quarter was tech as investors rotated out of tech stocks and into cyclical sectors as they positioned for an acceleration of economic activity that is expected to come with a full economic reopening. Traditionally defensive sectors such as utilities, health care, and consumer staples also underperformed the S&P 500 on the expectations of a strong economic rebound.
Internationally, foreign markets saw positive returns in the first quarter thanks to declining COVID-19 cases, continued progress on vaccinations, and initial signs of an economic reopening across the EU and UK. Emerging markets also rallied in the first quarter on hopes of a global economic recovery, although they underperformed foreign developed markets due to headwinds from a stronger U.S. dollar and economic turmoil in Turkey following the firing of the head of the Turkish central bank. Both foreign developed and emerging markets underperformed the S&P 500 in the first quarter.
Commodities posted strong gains for the second quarter in a row and notably outperformed the S&P 500 over the past three months. Major commodity indices were led higher by a large rally in crude oil futures as investors anticipated an increase in demand for both oil and refined products as the global economy begins to normalize. Gold, however, posted another quarterly decline despite rising fears of higher inflation, as a stronger U.S. dollar combined with the increasing popularity of alternative investments such as Bitcoin dampened demand for the precious metal.
Fixed Income Markets
Switching to fixed income markets, quarterly total returns for most bond classes were negative for the first time in more than two years. Massive economic stimulus combined with COVID-19 vaccinations led to an acceleration in economic growth expectations in the coming months, but that also resulted in a surge in inflation estimates, which topped a five-year high in the first quarter and that weighed broadly on the fixed income markets.
Looking deeper into the bond markets, longer-duration bonds underperformed those with shorter durations in the first quarter. That substantial underperformance was driven by the Fed’s consistent promise to keep short duration interest rates unchanged while the market priced in higher future levels of inflation, which pressured bonds with longer-dated maturities.
In the corporate debt markets, lower quality but higher yielding bonds handily outperformed investment grade bonds. That further confirms that during the first quarter of 2021 investors were positioning for a broad economic rebound later in the year. Investment grade corporate bonds underperformed as investors embraced more risk in their fixed income portfolios and as the decline in longer-dated Treasury bonds weighed on higher quality debt.
Second Quarter Market Outlook
As we begin the second quarter, the outlook for markets remains broadly positive. Monies from the recently passed stimulus bill are now entering the economy on a personal, corporate and government level, and those funds should help to spur economic growth in the months ahead.
Additionally, while the COVID-19 outlook has recently dimmed in Europe, the outlook for the U.S. remains generally positive. Vaccine distribution continues to accelerate, with the goal of having vaccines available to all adults nationwide by May. As a result, it is not unreasonable to think the pandemic will be declared “over” by the early summer (although obviously COVID-19 inflections will continue, just not at a pandemic level that requires a large-scale government response).
Meanwhile, the outlook for the economic recovery remains bright, with improvement across multiple economic indicators, while the Federal Reserve has pledged numerous times in recent months to continue to keep interest rates low and its quantitative easing (QE) program ongoing until the economy returns to pre-pandemic activity levels.
Those factors all provide substantial support for markets as we begin the second quarter.
But as the first quarter clearly demonstrated, there are always risks that need to be monitored. First, rising bond yields caused volatility in late February and throughout March, and if the pace of the rise in bond yields accelerates, we can expect more stock and bond market volatility as high interest rates are a threat to the economic recovery.
Similarly, investors are expecting inflation to accelerate as historically massive stimulus fuels the economic recovery. Right now, Federal Reserve officials expect any increase in inflation to be temporary, but if that expectation proves to be incorrect, then the Fed will have to remove stimulus via a reduction in the current QE program, and that is not priced into markets right now.
Regarding the pandemic, while the trend in the U.S. is clearly positive, parts of Europe are struggling with vaccine supply, and there is always the risk of a broader vaccine supply disruption or of a new COVID-19 strain that renders vaccines less effective, and any of those events would pose a threat to the rally in the stock market.
From a fiscal standpoint, the multiple rounds of stimulus that have been unleashed upon the economy since the pandemic began have resulted in very large increases to the national debt and federal deficits, and the recently passed stimulus bill only exacerbated those existing issues. So far, markets haven’t experienced any negative impacts related to the growing debt or deficits, but these high levels of debt and deficits represent longer-term risks to U.S. financial stability, and it remains unclear when those risks will begin to impact asset prices.
Finally, so far in 2021 markets have embraced the Democratic agenda of more economic stimulus. However, numerous prominent Democrats are also in favor of increased corporate, personal and investment taxes, and if those efforts gain momentum, we can expect that to have a negative impact on equity returns.
In sum, the start of 2021 showed that even though 2020 is behind us and the pandemic is likely closer to the end than the beginning, volatility and macro-economic surprises will remain with us, and as such we should all remain prepared for continued volatility.
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Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President
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