The sun is shining, the birds are happy and everywhere we look our eyes delight in the new leaves and unfolding flowers, Happy Springtime 2021! Somehow this spring seems especially sweet as we get closer to the end of this tough time of pandemic. And we’re all looking forward to a better world as the vaccinations become widespread and the number of new cases fall.
In addition to the seasonal growth and the longer days of spring there seem to be green shoots wherever we look in the markets and economy. Granted there was some pruning in a few areas with tech stocks trimmed a bit and bonds of all kinds trimmed back as rates increased. Overall though we’ve seen continued strong growth in the equity markets and good things happening economically as more sectors open up and more folks go back to work.
As we think about this last quarter three major themes present themselves for our review: growth in the economy, increases in interest rates and significant fiscal and monetary stimulus. Of course, neither stand alone and all are woven into the fabric of broad economic progress and market activity. But these three seem to comprise the major threads in last quarter’s tapestry.
Longer term interest rates rose significantly over this last quarter. They had been creeping up since August but pushed significantly higher in the new year. Rates had been at historical lows through much of last year, so an increase wasn’t unexpected, but the pace of increase was notable and certainly influenced bond prices as rising rates tend to push bond values lower.
Why did rates rise? At the most basic level interest rates tend to track inflation over time. We’ve had very modest rates of inflation over the last decade and the recession caused by the pandemic kept expectations for inflation quite low through the first half of last year. As light appeared at the end of the recession’s economic tunnel however folks could look ahead to the potential for higher inflation based on faster growth combined with constrained supply and so bond yields started to adjust. The stimulus bills of last year and early this year exacerbated those concerns as the prospect of trillions of dollars flowing out into the economy provided some additional reasons to be concerned about inflationary pressures.
Rising rates can affect how investors think about stock market valuations. One of the major inputs in determining a fair value for a stock or a stock market is the risk-free return that can be earned in other places. Low interest rates allow for higher stock market values as folks consider the potential for returns over time. Rising rates alternatively can reduce the amount investors are willing to pay for stocks. As such there has been concern about market valuations changing with higher rates although we haven’t seen those concerns manifest themselves significantly in equity market prices so far this year.
Stocks can more easily tolerate higher interest rates if the reason for the higher rates has to do with increased economic growth. Stand-alone inflation in an otherwise stagnant economy is very different from modest inflation that might occur during a period of rapid economic growth and growing corporate profits. Remember, the most important component of valuing a stock or stock market is the projected growth in profits for the company or for the market as a whole. In this way the stimulus measures, along with the natural rebound from the declining effects of the pandemic, have brought cheerful prospects of significant growth in the economy and the potential for a rising tide that will lift most boats. That has seemingly allowed stock investors to discount higher interest rates and instead look to earnings estimates that have been upgraded as the economy improves.
There are concerns about overall market valuations. Stocks are trading at higher-than-normal prices when measured against future earnings estimates. As we’ve mentioned before there are a couple ways that markets can deal with this. The first is a good old-fashioned selloff that brings valuation down to a level folks can feel comfortable with. The second, though less dramatic, can also be effective. Share prices can either move sideways or grow more slowly as corporate earnings catch up with current valuations.
So far this year the latter scenario has seemed to play out. According to information compiled by The Daily Shot from Bloomberg data, the last couple year’s price movement in equities has mostly come from “multiple expansion”, the willingness of investors to pay a higher price for a dollar of earnings. So far this year though, the increase in prices has mostly come from upgrades to earnings estimates as the stronger economic expectations translate into an improved earnings outlook.
It seems somewhat safe to assume a significant recovery in the economy from here. We’ve come a long way, but we have quite some ways to go to get back to the level of economic growth and employment enjoyed before the pandemic wreaked its havoc. Just how the various markets will react to the many inputs in play is anyone’s guess. We do have a clear idea about the most sensible investment strategy to weather the as yet unknown ups and downs in the future. Staying broadly diversified will continue to be the most effective strategy to both participate in the upside and have meaningful protection against the inevitable market declines along the way.
In addition to overall diversification our investment philosophy includes implementing steps to take advantage of valuation changes in the various asset classes on a relative basis. As growth stocks continue to look a bit expensive relative to value stocks and the broader market we’re taking steps to trim back those holdings a bit and gain some additional exposure to value stocks. In addition, we’re in the process of making some adjustments to holdings of international bonds to better align that part of the portfolio and reduce potential volatility.
We’re sure glad it’s spring, both seasonally and also figuratively, coming after this long pandemic induced winter hunkered down in safe places. We’re pleased to see the economy gaining ground and hopeful that the recovery will continue to gain steam and move us back towards the freedoms and opportunity that come with further vaccinations and businesses able to reopen. It has been a long tough slog and we’re excited about the prospect of an easier road ahead
We do not provide legal or tax advice. Readers should consult their own legal or tax advisor. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. Investors should talk to their financial advisor prior to making any investment decision. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.