Epic Liquidity, Abnormal Opportunity, and Uncommon Risk
The abrupt reversal of trends that began last November continued throughout the first quarter, as investors anticipated the reopening of the economy. In the financial markets it was most evident in the resurgence of value stocks, the associated recovery in energy, and the dramatic reversal in inflation expectations and interest rates.
As a category, value stocks outperformed growth stocks by the widest margin in over 20 years. Further, the resumption of economic growth sent inflation expectations, commodity prices, and interest rates skyward. In fact, oil prices and interest rates have more than doubled off their respective 2020 lows. This caused leadership in equities to shift to the energy sector, subdued growth-stock returns, and created challenges for long-dated bonds.
We identified the opportunities in value and energy and avoided the risk in fixed income well before the rotation in markets was established. Finding these pockets of opportunity led to what we believe were solid gains for the quarter. The foundation of our approach has always been to look over the horizon, searching for tomorrow’s quality investments at levels of risk that put the odds of success firmly in your favor. We have found this drives consistent, long-term compounding of absolute returns and avoids large declines that can interrupt years of gains.
Currently, we see disparities in the markets that offer the potential for compelling returns. However, we believe valuation risks surfacing as a result of the government’s unprecedented fiscal and monetary stimulus warrant some caution. While a rekindling of economic growth should provide a fundamental boost for reasonably priced stocks, it’s being accompanied by higher inflation expectations and rising interest rates. Both can be quite destructive to overinflated assets. Therefore, gaining a clear understanding of tomorrow’s earnings and the relative attractiveness of today’s prices has never been more essential.
An Awakening for Value with a Contemporaneous Energy Recovery
The resurgence in economically sensitive value stocks has been fueled by an expected strong recovery in the earnings of these companies. The main catalyst has been the reopening of the economy resulting from the increasing availability of coronavirus vaccines. Prices have been further supported by attractive valuations and continuing fiscal and monetary stimulus by the federal government.
The greatest distortion within value-based sectors over the last six months has been unambiguously evident in energy. The sector had been starved of capital for the last several years and the economic shutdown of 2020 provoked an inconceivably low oil price coupled with decade-low valuations for the sector. While the market was fixated on energy’s underperformance, we viewed its effective de-risking as an opportunity. Last March, with prices near their lows, we overweighted the sector in selected strategies. Early this past quarter, we more broadly accentuated our exposure based on a continuing positive outlook.
The chart below shows the sector returns for the S&P 500 for the first quarter. It highlights the rotation to value as the top-four-performing sectors are their primary components. Conversely, the bottom half is populated by traditional growth stocks. Anticipating this shift, we have maintained a healthy overweight to value stocks in our portfolios for the last several months. Even after adjusting for their recent performance, we still find value to be far more compelling than growth and are looking for opportunities to add to our positions as the earnings picture becomes clearer.
Avoiding the Risk of Duration
The heightened prospects for economic re-opening have also contributed to a sharp rally in commodity prices and caused GDP growth estimates to strongly increase. This has started to grab the attention of investors as they are beginning to anticipate an abnormally sharp increase in inflation. Indeed, forward inflation expectations have shown their greatest incremental change in over a decade, causing interest rates to increase and the prices of long-dated bonds to fall.
The chart below shows the last five years of yield data for the 10-Year U.S. Treasury Note. The reversal is unambiguous, as the yield has risen over 80 basis points year to date and over 120 basis points from last year’s low. This corresponds to a greater-than-10% decline in its price. Further, the Federal Reserve has promised to underwrite the recovery until employment levels return to normal. This would include a change from past behavior, as the Fed has indicated a willingness to allow inflation to run hotter than previous ranges. The bond market is on alert to the potential risks at hand and would likely send interest rates higher and prices lower if concerns mount. Accordingly, we continue to keep portfolios safely positioned in shorter-maturity bonds.
While the impact of rising rates has been most obvious for the bond market, it has started to spill over into the performance of growth stocks. Ultimately, the level and the rate of change of interest rates are two of the key determinants governing asset prices. Rising rates are particularly problematic for long-duration growth stocks because so much depends on increasingly strong future earnings that have yet to materialize. Rising costs, including rising interest rates, are an impediment to this. To date, growth stock prices have largely paused, and their valuations remain extremely expensive. Should interest rates continue to move higher, they are vulnerable to a large price correction. Therefore, we continue to underweight this category.
An Unparalled Fiscal and Monetary Response
Government measures to move us beyond the pandemic continue. While the scale and scope of this support may have been warranted to prevent economic disaster, policymakers could well be grappling with the aftermath as well as the unintended and as-yet-unknown consequences for many years to come.
Last year, government spending reached 44% of GDP, which is the highest in the post-WWII period. Most recently, the American Rescue Plan added an additional $1.9 trillion of federal relief, bringing the total cost of legislation designed to combat the impact of the coronavirus to more than $5.3 trillion. In addition, the Biden administration has outlined an infrastructure bill that exceeds $2 trillion for upcoming congressional consideration. As of March 1, our national debt exceeds $28 trillion and continues to rise. This is nearly 130% of GDP, and while the exact tipping point is unknown, debt of this magnitude is likely to restrict the government’s ability to respond to the next economic crisis.
The fiscal support we have seen thus far is only one piece of the story. The monetary side, underwritten by the Federal Reserve, has provided additional support of epic proportions. The Fed’s balance sheet has more than doubled over the last 18 months. This unrivaled support of the financial system dwarfs the efforts provided during the Global Financial Crisis (GFC). The Fed now has over $7.7 trillion in balance-sheet assets and it continues to grow. This compares to less than $1 trillion before the GFC. We believe that continued growth of the balance sheet at this level could be highly inflationary and would need to be addressed at some point. The last time the Fed unwound an expansion of this nature, rates increased, and equity prices tumbled. Presumably, the markets will be keeping close watch.
One immediate consequence of the government’s response can be examined through what we believe to be an extreme rise in asset prices. Stock prices are often one of the first places excess monetary support manifests itself. Home prices and commodity prices have also benefited from this current-cycle phenomenon. If history is any guide, these excesses are likely to correct and severely impact a generation of investors who got caught up in the momentum and turned a blind eye to the risks.
Navigating such a treacherous path will not be as easy as simply owning a diversified pool of assets. A comprehensive review of various published Capital Markets Assumptions would suggest that the forward return environment is not only low for both equities and fixed income, but it may also offer more downside volatility than many anticipate.
We believe a dynamic process that identifies and captures pockets of opportunity (such as value stocks and energy) and steers away from unwanted levels of risk (like rising interest rates) will be a requirement for success. Further, portfolios are likely to include selected traditional market assets and timely non-traditional alternatives. Both are among the opportunity sets for our portfolios, and our investment team has extensive experience dynamically managing assets in both universes.