The Profits Tug-of-War
Dear Clients and Friends,
They say hope springs eternal, and we cannot help but find ourselves optimistic as longer, warmer days of spring coincide with more prevalent vaccinations and a significant improvement in Covid related news. Although hopeful, we remain vigilant as the pandemic has offered its share of surprises for the global community, markets, and investors.
Stocks in the first quarter reflected this cautiously optimistic tone, with broader markets overcoming some bumps in the road to finish up 6.2% in the first three months of the year. Looking ahead, we expect two key themes to set up a profits “tug-of-war” that may determine market performance for the remainder of the year: earnings upside and rising taxes.
But first, let’s review the first quarter of 2021, which saw two bouts of volatility that almost torpedoed broader markets. In late January, a surge in retail investor interest sparked by Robinhood and social media platform Reddit eventually ended in steep losses for broader markets. Then in early March, a spike in 10-year Treasury yields spooked equity markets as investors weighed the possibility that inflation might lead to a rate hike by the Federal Reserve (which could slow economic recovery). Despite the intra-quarter volatility, markets ended the period reflecting longer term trends such as the new $1.9 trillion fiscal stimulus and a more broad-based economic reopening, both of which should accelerate economic growth.
Growth, Inflation, and the Bond Market
As recovery continues into the second quarter, investors are trying to gauge whether the economy will be too hot, too cold, or just right. A massive public health effort has injected more than 2.5 million vaccine doses per day, and this run rate seems likely to match investor expectations for economic recovery. Vaccines, coupled with the latest stimulus, should help millions of unemployed workers in travel, leisure, and hospitality get back to work.
However, investors are wrestling with a potential inflation risk, especially if the stimulus drives short-term demand above supply, pushing prices up. While we are open to this possibility, we see low odds of a wide-reaching inflation scenario in the near-term; wage pressures generally drive the bulk of America’s inflation, and wage growth has been modest for over a decade. At this point we expect higher volumes of economic activity (rather than price spikes) to drive about 5.7 % GDP growth this year—quite an improvement from 2020’s (3.5%) GDP decline.
The bond market has taken notice of higher growth and inflation expectations as the 10-year Treasury yield nearly doubled from 0.9% in January to 1.7% last month. Despite the recent bump in interest rates, our sense is mainstream bond market yields will remain below historical levels for some time. With this in mind, in the first quarter we continued to add to equities with decent yields, as well as corporate and municipal bonds. With rising 10-year U.S. Treasury yields pushing intermediate and longer-term rates higher, we took advantage of opportunities to purchase additional corporate bonds and preferred shares at more attractive yields.
Will Taxes Halt the Profit Surge?
We anticipate that a confluence of events will impact equity markets during the balance of the year including vaccine progress both here and abroad, fiscal stimulus, Fed actions, and inflation risk. Still, we would boil these down to two factors at opposite ends of the tug-of-war for stock prices: upside profit momentum resulting from reopening the economy and downside risk from higher taxes.
Historically, stocks have chased earnings (or profits), and we expect that to continue for the remainder of the year. The question is whether investors will focus on 2021 or 2022 earnings. Earnings in 2021 may surge when compared to 2020’s earnings contraction. As the economy continues to recover with support from additional fiscal and monetary stimulus, driving stocks higher. However, the potential for significant tax hikes may derail the market upswing if investors anticipate a 10%+ headwind to after-tax earnings in 2022. Overall, we see a bit of a middle ground here since stimulus-driven upside may moderate tax hike pressures.
How are We Positioning?
We expect the profits tug-of-war to drive modest market returns for large cap U.S. companies over the next year. Although blue chip U.S. stocks have outperformed for the past decade, our sense is a gradual shift toward international diversification may look more compelling in the future.
We expect to hold a majority of equity assets in broader U.S. markets for some time, but we also see room to diversify into developed and emerging markets outside the U.S., as well as small and mid-cap companies domestically. In the first quarter, for example, we increased our exposure to Asian technology companies and European electric vehicle (EV) manufacturers.
Looking ahead to a sustained global economic recovery, we see opportunities for small and large companies to generate earnings growth in both U.S. and international markets. As the year unfolds, we will continue to identify asset classes and securities with attractive risk-reward profiles that meet our core investment principles, remaining ever mindful of your goals and objectives.
With warm wishes for spring,
Michael Bailey, CFA Michael Mussio, CFA
Director of Research President