The St. Nicholas Viewpoint: 2021 First Quarter Outlook
by Tim Cebulko CFA/CFP, President, Chief Investment Strategist April 15, 2021
We’ll start this particular letter with a couple of housekeeping issues. Last quarter’s letter talked about the tremendous returns we achieved in 2020, not only on an absolute basis, but for St. Nicholas clients in particular on a relative basis. One impact of this outperformance was a material increase in the growth of the assets that we have under management, both in terms of existing accounts and new accounts. The effect of this growth elevated our total assets under management to the level which now requires SEC registration and regulation. In the past, while we had always filed annually with the SEC, we were actually regulated by the State of Florida. Going forward, regulation oversight will now fall under the SEC’s purview, and the compliance requirements of the SEC will replace those of the State. These requirements are generally more strict and wider in scope, and so we may occasionally surprise you with regulatory releases, requests, disclosures, etc., that you had not been bothered with before.
In that regard, we have added Form CRS to this website. Form CRS is short for customer or client relationship summary. It’s a brief document, limited to two pages for individual firms, that SEC-registered brokers and financial advisors are now required by law to provide to prospective clients to disclose specific facts about the services they offer. In our opinion, it’s basically a condensed version of the Investment Advisor Brochure already filed with the State and SEC annually. Happy Reading…
First Quarter Performance Review
Global market returns were positive across the board – that is of course, unless you were in bonds. Fourth quarter equity returns were all positive, but bonds experienced one of the worst quarters they’ve had in years, losing almost 4.5%. We’ve been warning that bonds had a tough road ahead, and first quarter returns are likely still only the beginning. As far as equities go, tech stocks temporarily lost some wind, while basic economy stocks had their run. That being the case, it isn’t a surprise that the best quarter was had by the most basic of stock indexes, the Dow Jones Industrial Average. The DJIA led all major indexes, returning 8.3% for the quarter. Domestically, the Dow was followed by the S&P 500, returning 6.2%, and the tech-heavy NASDAQ, up just 2.8%. International markets were led by Japan and China, with the Nikkei up 6.3% and the Hang Seng up 4.2%. Developed International (MSCI EAFE) was not far behind, up 3.6%; and bringing up the rear was emerging markets (MSCI EM), up only 2.3%.
The Fed continues to remain resolute in its monetary approach as the economy winds its way up from the bottoms created by the Covid virus. Federal Reserve Chairman Jerome Powell is very consistent in his rhetoric describing what the Fed sees and what the near future holds for interest rates. He regularly testifies before Congress, answering what are often biased questions designed to entrap the Fed Chair into political corners favoring unrevealed but underlying motives known only to the Congressional questioners. While these clumsily sly tactics are embarrassing and difficult to watch, we give credit to Chairman Powell for keeping his cool and answering only what applies to the Fed and its actions.
Mr. Powell went through a similar assault in his recent appearance on the television “news” show 60 Minutes. Long known for its overtly liberal and sensationalist approaches to reporting only the news they want us to hear, the Powell interview was nothing different. Regardless, we give Chairman Powell kudos for refusing to allow 60 Minutes to paint him into an anti-Trump or pro-Biden corner, and instead focusing on the oft-repeated but unchanging outline that he has for interest rates and inflation. In short, it was reassuring to hear that the Fed sees no rate increases for the balance of this year, and that they could not commit to if/when rate increases might happen next year.
The long-term inflation target remains 2%, and Powell was quite diligent in discussing the history of inflation and what the Fed has learned about controlling it over the years. The Fed looks at many economic statistics, but no longer sees things the same way Fed Boards looked at things 40 years ago…nor should they. Today’s modern economy is much different and certainly more dynamic. The Fed still maintains targets for inflation, long-term average growth, and full employment, but is quick to point out that there are also many other moving targets. What we appreciate most is this Fed’s abject refusal to give any hint of political pressure or leaning. Political independence is key to our national banking system and we are comforted that the Fed’s apolitical stance continues to be emphasized. Congress has fiscal policy as its tool and the Fed has monetary policy, and neither should have any influence over the other. Let’s hope it can stay that way.
The Equity Markets
The traditional equity consideration continues to be clouded by the absence of fundamental data. In spite of the obvious knowledge that a tremendous economic recovery is forthcoming, there remains little confidence in the ability to actually predict revenue and EPS growth. Professional analysts are simply not willing to put themselves out on the proverbial limb with estimates that are overly optimistic. The end product then is unreliable and likely very conservative estimates across the board. Companies themselves are taking the same approach. We had a noticeable handful of companies that we own beat consensus estimates last quartier by sizeable margins. However, rather than see their stocks get rewarded for outperforming expectations, many of them got dinged simply because they were not willing to confirm estimates for the balance of the year. This in itself is not a long-term problem – prices eventually catch up with earnings and these stocks’ prices will certainly reflect their improving earnings pictures as they are confirmed in the coming quarters.
Shorter-term, we expect the pattern to continue. It is pretty telling, however, how all of the companies that refused to provide estimates, now see their stocks begin to rally into the next earnings reports for the present quarter. This is true evidence of the last sentence of the previous paragraph. While these stocks might have gotten punished in the very short-term for a lack of future estimates, investors are already beginning to discount the expectation that those companies will beat estimates again this quarter. Those same stocks are already starting to climb noticeably. The question remains though, as to whether they will hold their gains if/when they again fail to provide estimates for the balance of the year. This up and down stair-step pattern will likely persist throughout the year, reflecting unnecessary volatility but still rewarding investors in the long run, with the stairs eventually ending up at higher highs each quarter. While this is certainly an annoyingly volatile pattern, it appears to be an appropriate reflection of the post-Covid recovery.
Speaking of the recovery, looming questions remain as to how strong the recovery will be; how long it will last; and, most importantly, have the markets already discounted the magnitude of it? Remember last year when the world was in the abyss of the Covid pandemic and the economy remained at least partially closed for much of the country? Stock markets at the time recovered quickly and continued to eventually increase to new highs. Realistically, most of the stocks that make up the major indexes remained down, while the top 5 to 10 of the biggest names (technology stocks), which made up as much as 25% of the indexes, soared and ultimately carried those indexes with them. We said at the time that the market is a discounting mechanism and that the upward moves in stocks back then was in anticipation of what the economy would do 12 to 18 months out. We are now at 12 or so months out (depending on your starting date) and we think the market was adequately discounting the coming economic rebound.
The issue now is whether the “discounting” was too much, too little, or just right. It’s actually an even bigger question today considering that the market has continued to rally. Another 10% increase in prices so far this year is a good sign that the rally last year was understated and that the 6%-7% growth expected for the balance of this year will benefit earnings a bit more than originally expected. The extended rally could also be an indication that the recovery will be stretched out longer than expected. This conclusion isn’t really surprising given how long it will take to continue the vaccine rollout combined with what we’ll label the ‘hesitancy factor’ – the reluctance of consumers to fully participate in normal activities even after herd immunity is declared. This isn’t to say businesses won’t be crowded, only that they won’t be as crowded as they could be.
We’ll conclude that we think the stock market is doing a decent job of discounting economic activity 12-18 months out. Our concern, however, is that we don’t yet have a good grip on when the market will begin to discount the inevitable end of the Covid bounce. We don’t feel like that will happen before the end of this year, but it’s undeniable that it eventually will happen, and that will mark the end of this boom cycle. The strategy in the meantime is to maintain and/or maneuver positions in stocks that will continue to reflect the near-term rebound but still possess the quality characteristics necessary to hold strong during the next downturn.
With deference to the great English rock band Led Zeppelin, ‘the song remains the same’ as far as the bond market goes. We have already seen the bottom in interest rates, which only means the road to the bottom in bond prices (and thus the peak in interest rates) should continue to prove to be a long and arduous journey. We’ve already hit a pretty big bump in the first quarter, with corporate bond returns showing their worst quarterly performance since 2008. Improving economic forecasts for 2021 combined with an acceleration in inflation fears, pushed yields to unexpected highs, with the 10-year US Treasury yield rising as high as 1.74% after starting the year below 1%. This was a huge move percentage-wise and took a toll not only on bond prices, but temporarily hit growth stocks pretty hard as 1.5% was the self-designed “target yield” in which growth stocks supposedly begin to lose rate-enhanced growing power. While there is no denying that growth stocks definitely stalled, we must remember the rather arbitrary 1.5% level is merely a temporary target for fear-inducing short-term traders. As proof, there was no corresponding short-term rise in growth stocks on the way down from 1.5%, mainly because the “threat” of lower rates on these stocks does not stir fear in anyone, and the enticement to trade is non-existent. Nonetheless, we expect this 10-year rate, and rates in general, to stall out near current levels, supported mostly by strong foreign demand given that US rates are attractively much higher than most major non-US markets.
On the municipal front, it’s worth passing along that this sector fared better than corporate bond in the quarter, although it still finished in the red. The reason might be the notion that the prodigious Covid relief package, when it eventually passed, would provide massive funding to some of the hardest hit states and municipalities. Indeed, the $2 trillion relief plan promises to not only enhance the growth of the tax bases of these economies, it provides over $350 billion of direct payments to various state and local governments. Boosts like these immediately enhance the credit quality status of municipal borrowers, and we continue to expect even more improvement on that front with the passage of any kind of infrastructure bill, that will undoubtedly include indirect growth enhancements and even more direct payment relief. Muni rates are still nowhere near levels that are worth chasing, but at least we’ll be looking at better credit quality levels when we eventually do.
Speaking of all of this relief spending, we must not forget that there is a trade-off. There is little doubt it will help a devastated economy, but at what cost? Who pays for all this? Yes, you and I to some tiny extent, but the bulk of this massive spending will be borne by our progeny. In my case, my children’s grandchildren will still be paying for this, and probably beyond even them. Yes, we’ve been told tax increases will help, but the numbers we’ve seen simply just don’t make a dent, and raising taxes even more will kill economic growth for years. Thus, we are left with the philosophical/political dilemma: how much fiscal stimulus is truly needed for a recovery that, absent this stimulus, would be naturally occurring? How much is enough? While there are certainly segments of society that have been hit extremely hard, there are many other parts of the economy that not only survived, they are comfortably recovering on their own. Do we really need 7% growth (a huge, almost unprecedented level) for the next several quarters when we’d be looking at 3%-5% without all of the extra spending anyway? Are we sacrificing long-term inflation and dollar-strength for what will historically turn out to be a very short-term recovery? We won’t pretend to have the answers, but we know consequences come with actions and we are very concerned that many of these actions are being taken with little or no regard to long-term consequences. In the short term, however, it’s all sunshine, lollipops, and rainbows…isn’t it?