- With Q1 in the books the equity markets posted solid returns across the board while fixed income was hurt by rising interest rates.
- Economic data continues to improve as job losses slow and growing vaccinations help ease covid restrictions supporting higher consumer confidence.
- Inflation has moved to the forefront of concerns for the market after the passage of the American Rescue Plan amid record amounts of stimulus.
- In March, the rotation from Growth to Value continued favoring Large-Caps over Small-Caps.
With the first quarter of 2021 already in the books, positive economic data points to a sustained recovery for the remainder of the year. Consumer confidence is beginning to improve. The Conference Board Consumer Confidence Index® increased to 109.7, its highest reading in a year. Consumer’s assessment of current business and labor market conditions and their expectations for income, business, and labor market conditions both rose considerably. The University of Michigan Consumer Sentiment Index confirmed similar outlooks with the index finishing at its highest level in a year at 84.9 an increase of 8.1 points for the month and the largest increase since April of 2009 mostly due to the passage of the American Rescue Plan and increased investor optimism regarding improved vaccine distributions and loosening restrictions1.
The IHS Markit U.S. Services PMI increased to 60 its highest level in 80 months mostly due to higher demand seen with looser COVID-19 restrictions as the spread continues to decline and vaccinations increase. The IHS Markit U.S. Manufacturing PMI increased to 59 for the month but the increases are slowing as supply shortages continue to constrain manufacturing output and manufactures have trouble filling job vacancies. Input prices and selling costs rose faster than any point in the survey’s history with some of those costs being able to be passed through to the consumers due to high demand2.
The most recent weekly initial jobless claims, a proxy for layoffs, increased to 719,000. The 4-week moving average, which smooths out the trend fell to 719,000 marking the lowest level since last March. Continuing claims, or those who are continuing to claim regular state unemployment benefits, also fell to 3.79 million, a decrease of 46,000 from the previous week’s level. However, there are still approximately 18.2 million people claiming some form of state or federal benefits which continues to signal the difficulty people are having finding employment. That could be changing as well though. On Friday, U.S. employers added 916,000 jobs in March, the best gain since August, while the unemployment rate also ticked down to 6%. Job growth was widespread in March, led by gains in leisure and hospitality, public and private education, and construction3.
The market continues to reflect the improving economic backdrop and anticipation of a return to normalcy that greater immunity through vaccinations and antibodies will provide. In large part, equity indexes are up through the first quarter while fixed income was hurt by rising interest rates. There is an inverse relationship between bond prices and interest rates. As rates rise, bond prices fall. Small and mid-capitalization companies outperformed as investors continued to rotate into more cyclical industries which comprise a larger portion of the small and mid-cap space. The Nasdaq lagged as those companies’ ability to finance growth through debt was negatively affected by rising rates. The lofty valuations of many of those companies compounds the problem as their earnings and/or future earnings are worth less with higher interest rates. From a valuation perspective many areas of the U.S. market are trading above their historical P/E levels. The S&P 500 finished the quarter with a forward P/E of 21.88x. Still when compared with bond markets equity markets continue to look undervalued. Developed international and emerging markets also look attractive from a relative valuation and long-term economic growth viewpoint.
However, as the economy continues to improve the market has grown increasingly concerned that as life begins to return to normal, pent-up demand and records amount of stimulus will drive inflation higher. In February, the PCE Price Index, which is the Fed’s preferred measure of inflation, rose 1.6%, while core PCE rose 1.4% on a year over year basis. Core PCE excludes food and energy prices which tend to be more volatile. The chart below shows the yearly percentage change in core PCE with the orange line denoting the current 2% inflation target. The inflation target was started in 2012 in hopes of helping to promote the Federal Reserve’s dual mandate of maximum sustainable employment and price stability. We can see that over most of the last decade inflation has fallen below 2% except for a short period in late 2018 where inflation began to creep above the target rate.
If we look back to that period it was a time of tremendous volatility. From October 3rd through December 24th the market fell nearly 20%. This was less so because of inflation fears and more so worries that the Federal Reserve was raising interest rates too fast which would stymie economic growth. While not completely analogous, the general idea still stands. The markets do not like uncertainty and the possibility of the Fed having to reverse course and raise interest rates too quickly because of runaway inflation continues to drive volatility higher and the rotation from many of the high growth names to more cyclical and value-oriented stocks. The market is currently pricing in a 10.9% chance of the Fed raising rates this year compared with 0% chance at the start of the year.
These market updates give us an opportunity to highlight a few interesting aspects about the economy and stock market and then tie them together to illustrate the cause-and-effect dynamics at play. Of course, there is way more that can be discussed but for all your sakes we try to keep them relatively brief. The chart below shows the S&P 500 Index plotted over time. The numbered circles are moments in history that are exceptionally memorable. In order, 1 – Asian Financial Crisis and Long-Term Capital Management bailout; 2 – Tech bubble and 9/11; 3 – Global Financial Crisis; 4 – European sovereign debt crisis; 5 – Eurozone double dip recession; 6 – Oil, U.S. Dollar strength fears, China; 7 – “Holiday” interest rate crash; 8 – COVID-19 Pandemic, global slowdown, and oil price collapse. For a sense of scale, circle number 1 was almost a 20% decline.
These are just the big events and would have probably been worthy of discussion in any Monthly Market Update for at least a few months. But there have been trade wars, geopolitical crises, political populism worries and more over the years that still caused a great deal of market uncertainty and volatility. The thing is that they are all transitory. Your goals and objectives don’t stop at Circle #7. As Financial Advisors and Portfolio Managers our job is to help manage you through all these events and to remind you that your portfolio is built for the times outside of the circle as much as it is for the times in the circle. Always try to keep in perspective the reason for why you are investing and saving. For all of those who have placed their trust and confidence in us we thank you.
1Ned Davis Research – U.S. Daily Perspectives: March 26, 2021
2 IHS Markit Flash U.S. Composite PMI™
3U.S. Bureau of Labor Statistics – Employment Situation Summary