OSAM Client Portfolio Manager, Ehren Stanhope, shares our views on frequently asked questions we’ve received from clients and allocators throughout this eventful start to 2021. We hope you find this public Q&A informative. If you do not currently read Ehren’s daily note, you can start following it here: @FactorInvestor.
What a wacky quarter... an inauguration, fiscal stimulus, a storming of the U.S. Capitol, SPAC's, fund failures, YOLO derivative-fueled stock trades, yields doubling, big tech's fall from grace, the emergence of value and small cap, and waiting for each pronouncement from Central Bankers and Health Officials with bated breath.
Reflation stood atop the mountainous wall of worry that was the beginning of 2021 and foisted equity markets up and over. Re-opening stocks soared while stay-at-home's lagged. Inflation metrics really started to heat up.
The S&P 500 finished up roughly 6.2% on the quarter. The Tech-heavy Nasdaq came in around 2.8%, and the small cap Russell 2000 clocked an impressive 12.8%. The dollar surged 3.6%. While oil was up 36% at one point in the quarter—stoking inflation concerns. Oil finished Q1 "just" 22% higher. Energy stocks soared nearly 30% in sympathy. The US 10-year Treasury yield went from 0.9% to 1.7% in a massive bear steepener, the likes of which have not been seen for over a decade. It is easy to forget that we are technically still in a recession that started in February 2020.
Value eviscerated growth to the fanfare of many asset allocators – except Ark Invest. Momentum inverted while quality continued its attempt to re-orient itself from the pandemic inversions (poor quality outperforming high quality).
The short answer is “who knows”. We do not try to predict rate movements in our investment process. Many have tried; few have succeeded. Yes, rates matter, but only to the extent that they impact earnings and cash flows. Rates may rise, but corporations have varying debt maturities and may not be impacted immediately and/or may have multiple years to adjust their balance sheet for the given rate environment. Though we do not speak to management teams as part of our investment process, we have seen examples of otherwise strained companies refinancing their debt last year to give themselves multiple years of runway to operate.
It is also important to think of interest rates on a spectrum. Below is a chart of the U.S. yield curve as of 12/31/2019 (pre-pandemic), at 8/31/2020 (mega cap growth’s heyday and peak deflation sentiment), and the end of the first quarter of 2021. Note that short rates are much lower than pre-pandemic levels, but long rates are no different. Long rates were also extremely low during the malaise of late summer 2020 but have risen as inflation expectations increased.
This occurs because the Federal Open Market Committee (FOMC) controls short-term interest rates. In a Quantitative Easing (QE) environment, they are technically exerting control over longer maturities, but for the most part, ten years and out on the yield curve is a fixed income sector controlled by market forces. Long and short rates have different drivers so even though the Fed may raise short-term rates, that does not necessarily mean corporate borrowing rates and or mortgage rates — the rates most important to the real economy — will increase.
The Fed has done a reasonable job of threading the needle during the COVID crisis. They averted a lock up of the financial system in March 2020 and provided consistent support until the stimulus baton was handed off to the Fiscal side of the house.
The Fed will now look to withdrawing its stimulus through highly choreographed communications via Fed speeches and FOMC meetings. In advance of the first hike, it is anticipated that the monthly $120 billion QE purchases will gradually be reduced — a process commonly referred to as “Tapering”. Currently, the expectation baked into short-term market-based interest rate futures is for a 0.25% hike in Q4 2022 and rising to 2% by mid-2026. Market participants are much more hawkish than the Fed has communicated thus far, largely believing inflation will prove to run hotter than the Fed will ultimately be comfortable with.
Fiscal stimulus has kicked into high gear. The final stimulus dollar amount will not be known until the ink is dry, but it’s safe to say they are coming out in rapid succession and are well in excess of the New Deal and Global Financial Crisis (GFC) stimulus programs.
The White House basically has a limited number of shots each year via budget reconciliation, which enables a simple majority for passing controversial agenda items. Fiscal stimulus is morphing, however. The first few rounds were direct transfers from the Federal government to taxpayers. The most recent Biden proposals have included tax increases on corporations and high-income individuals. Most notably as it relates to capital markets — a proposed equalization of capital gains and income taxes.
Fiscal stimulus is a tricky instrument. It can directly inject funds into the economy — stimulus checks — but to some extent this is borrowing from the future to pay for current needs. U.S. debt to GDP is now as high as it was in the post-WWII era. The recovery from that period is instructive. However, sovereign entities rarely repay their debts. Rather, the debt simply gets rolled forward — kicking the can down the road. How do they do this? Inflation.
The post-WWII recovery led to massive inflation that peaked decades later in the early 1980’s. Since the rate of nominal economic growth exceeded interest rates on debt, the U.S. inflated its way out of a massive debt burden. Historically, this is very common. Currency depreciation offers another method for crawling out from the cave of sovereign debt. When experienced in extremis, high inflation and currency depreciation carry their own set of problems, but can be quite effective in moderation.
The Fed and Treasury are keenly aware of how rates impact wealth, income, corporate earnings, fixed investment, and liquidity. The last thing they want are skyrocketing rates. As many have mentioned, the interest on Treasury debt as a proportion of the fiscal budget would sky-rocket. Given the amount of leverage in the global financial system, such an event is untenable and would be avoided at all costs. That doesn’t mean we might not see 3, 4, 5% inflation, but the double-digit inflation of the 1970’s seems unlikely.
We are big believers in the long-term efficacy of value and shareholder yield (the combination of dividends and share buybacks). These two factors are benefitting from the reflation trade and appear to have much further to run if there are no major setbacks with the vaccine rollout.
International markets have lagged in the rollout and not participated in the reflation trade to the same extent. Historically, U.S. and International equity markets tend to outperform each other in long cyclical waves, with the prior period of International outperformance concluding with the GFC. Since then, the U.S. has outperformed substantially. It would not surprise us if International equity markets began catching up — assuming global vaccinations ramped up.
Expectations for mega cap growth are exceptionally high. Near year end, the gap in long-term earnings growth expectations for the Russell 1000 Growth and Value indexes was 18% (in favor of growth). That is a massive spread, and a historical high since long-term growth estimates have been tracked, which places very high expectations on growth companies. Disappointments in fundamentals versus expectations could be a headwind.
Overall, it seems likely that Monetary and Fiscal stimulus will continue to dominate the narrative and could invite some volatility — tapering, overshoots from transitory inflation, rate hikes, tax increases, etc.
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