Quarterly Commentary - Q2 2021
APW Investment Committee Q2 2021 Commentary
Q1 2021 Review
The strong US equity market rally continued into the first quarter of 2021. Small cap stocks continued to lead all equity returns and value stocks staged a rally that has them outperforming growth stocks for the first time in years. The key driver of the strong performance was a realization of significant progress against COVID-19 with U.S. cases dropping from a peak 7-day average of over 256,000 on January 11th to as low as 55,000 in mid-March. The massive improvement along with the rollout of vaccines (now at over 3 million doses per day) convinced market participants that the end is in sight. Economic results supported the strong stock market expectations. The first quarter 2021 real GDP came out this week at a very robust 6.4% annual rate.
On the fixed income side medium and long-term rates continued to rise causing the yield curve to steepen from a spread of only 34 basis points on 12/31/2020 to 158 basis points at quarter end, indicating that the bond market agrees that stronger economic times lie ahead.
Many countries in the world had significantly worse vaccine rollouts than the US. With US Treasury interest rates rising, this led to an unexpected rally in the US dollar. Both factors caused international equity markets to have more muted rallies, particularly in emerging markets.
In February, we initiated a portfolio rebalance that changed several portfolio positions.
- First Eagle Global Fund (SGIIX) was sold. While the fund was a solid performer historically (albeit with a poor 2020) we no longer felt the fund was providing the diversification we had initially sought and was obfuscating what are otherwise clearly defined exposures to various asset classes.
- That allocation was divided between the Invesco Emerging Markets Fund (ODVYX) and the Vanguard Russell 2000 Index ETF (VTWO). The goal is to add to our positions in areas that historically have performed well in economic recoveries.
- In addition, the iShares MSCI EAFE Minimum Volatility Factor ETF (EFAV) was replaced with the Vanguard FTSE Developed Markets ETF. This change was made due to our desire to take a more aggressive stance toward the global economic recovery.
- In aggressive portfolios all fixed income positions were sold and a new basket of funds was added that we are calling the Global Aggressive Growth Equity Sleeve. The four funds added were Matthews Asia Innovators (MITEX), Baron Global Advantage (BGAIX), Baron Discovery (BDFIX), and New Alternatives (NALFX) in equal weightings. The intention is to significantly increase the risk profile while adding overweights to areas such as alternative energy, technology, and early life cycle growth opportunities.
Last quarter we discussed the massive rise in liquidity initiated by Federal Reserve and US government actions. Since that time, another $1.9 trillion stimulus package was passed with talk of an even larger infrastructure bill on the way. As a result, the large US banks are all forecasting annual GDP growth for the year of at least 6% and some, like Goldman Sachs, are predicting 8%. Eight percent growth would be the fastest US growth rate since 1951.
In general, high growth rates are very supportive of good stock markets. When you combine high growth rates with lots of stimulus (“cheap money”) like those described above, it is like throwing gasoline on the fire. Eventually, that is how speculative bubbles form, but it can take a long time.
What do we mean by “cheap money?” Interest rates are sometimes called “the cost of money” because that is the rate at which you can borrow money. In a financial or economic crisis, the central bank will lower interest rates and the federal government will create money (issue government debt) to stimulate the economy. This action is a normal response to crisis. Once the crisis is averted governments and central banks typically try to sop up all that extra cash in the economy. Interest rates start to rise and the government tightens its belt.
Since August the 10-year US Treasury rate has risen about 1.1%. At first it felt like a fast move and many speculative stocks sold off. By mid-March things had stabilized and today we are still not yet back to pre-COVID levels. So interest rates are starting to respond to the improving outlook, but generally money is still extremely cheap. The federal government, meanwhile, is pushing aggressive stimulus as if we are not on the other side of the crisis. The Biden Administration has laid out plans to expand government spending in ways not seen since LBJ.
This expansion of government spending in and of itself is generally good for stock markets. After all, from a corporation’s perspective, money is green no matter who hands it to you. Conditions overall are very good for stock investing.
There is an old saying on Wall Street however, that bull markets climb a “wall of worry”. That is to say, there is always something that we think could cause markets to reverse course (in a hurry). Today there are two primary worries; further rising interest rates caused by fears of inflation, and rising taxes on corporations and the investor class.
As we mentioned in our last commentary, we believe that the primary driver of market performance will be what happens to interest rates. While they may continue to rise somewhat, we still do not believe that they will rise substantially (e.g. 10-year Treasuries above 3%) in the near term because of the incredibly competitive pressures in our economy. Put simply, it is hard to meaningfully raise prices on goods and services. In addition, interest rates around the world have not risen as fast as in the US. This is creating an opportunity in US Treasuries for foreign buyers and putting downward pressure on rates.
As for rising taxes, a full enactment of the Biden corporate tax hike would hurt profits by about 9% according to a Goldman Sachs analysis(1). They are estimating what they believe will actually pass however, will more likely be a 3% hit to US corporate earnings. Other potential tax hikes like a rise in capital gains rates on wealthy investors (greater than $1M+ annual income) could cause some short-term selling, but historically these kinds of changes have not had a long-term impact on market performance – put simply investors adjust.
So in effect, the current administration is putting a heavy foot on the accelerator and a lighter foot on the brake, and no one is sopping up any of the liquidity – quite to the contrary. As investors, we feel that there is still little choice but to keep higher than historical risk exposure within the expected range of our models.
Austin Private Wealth, LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Austin Private Wealth, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Austin Private Wealth, LLC unless a client service agreement is in place.