Key Points Remain:
- "Don't fight the Fed, the fiscal authorities, or the vaccines"
- Excessive optimism, stretched valuations and potential for higher interest rates and inflation are possible challenges
- Given probable tradeoffs, most Sequoia strategies remain generally neutral equities/fixed income, with modest tilts toward higher quality U.S. equities and lower fixed income duration than broad indices
Change was a key descriptor of the first quarter of 2021. Change in the White House, change in economic stimulus efforts, change in equity market leadership, and a big change in interest rates. But perhaps the best change was what may prove to be the beginnings of the end of the Coronavirus pandemic as vaccine distribution and administration ramped up significantly in Q1. Nearly 100 million people in the U.S. have received at least 1 vaccine dose and around 60 million are fully vaccinated as of the end of Q1 (see footnote 1). It appears these numbers are set to rise exponentially over the coming weeks as well. Add to that a highly accommodative Federal Reserve and fiscal authorities who have added $5 trillion in economic stimulus (see footnote 2) over the last year or so, and the mood around the pandemic and economy seems to be drastically improving.
As we discussed in our 2021 outlook entitled “Turning the Page on 2020” published in early January, we think the investing environment and positioning should be viewed through the lens of “Don’t fight the Fed, the fiscal authorities or the vaccines”. All three combined are a potent force that is likely to lead to one of the strongest economic growth rates in 2021 that we’ve seen in quite some time. Here is what we mean by each:
- Don’t fight the Fed: The Federal Reserve is creating money and buying $120 billion of treasury and mortgage back bonds per month (see footnote 2). This is commonly known as quantitative easing. Simultaneously, they are holding short term interest rates, the Fed Funds Rate, near 0% and have clearly communicated their intent to keep it there for the foreseeable future (see footnote 2). This is some of the most accommodative monetary policy one can imagine and is likely to continue to be supportive of the economy and financial markets. We don’t want to fight this powerful force until we see the possibility of this policy stance becoming less accommodative.
- Don’t fight the fiscal authorities: The President and Congress of two separate administrations have worked with the Treasury Department since last February to implement various economic stimulus packages that total around $5 trillion, which is around 25% of U.S. economic output (see footnote 2). It appears the Biden Administration is also pushing for another $2 trillion by year end for various forms of infrastructure (see footnote 2). This is one of the largest fiscal responses since WWII and are very powerful measures supporting the economy and financial markets. We do not want to fight it.
- Don’t fight the vaccines: This was a healthcare-related economic shock and a healthcare solution is allowing the global economy to reopen and start functioning more normally again. Given the significant distribution and administration of vaccines already noted, and what is likely to be an enormous global rollout of vaccines over the coming months, it seems reasonable to expect that we can start meeting with our families, going out to dinner and the movies, and reopen schools and places of work sometime in the not too distant future. Given all the stimulus efforts and the fact that all of us have been couped up at home, we think it also seems reasonable that the vaccines will allow us to get out and start spending all the stimulus checks, which is likely to lead to strong economic growth in 2021. If you recall, Consumer spending accounts for roughly 70% of the US economy (see footnote 2).
Many things changed in Q1 2021, but the power behind these three factors has not. Financial markets have clearly taken note and responded accordingly. One of the biggest changes and challenges for the markets in Q1 was rising interest rates as fixed income markets began pricing in much higher expected economic growth given the power of these 3 factors. For example, the yield on the 10-year Treasury Note rose from 0.93% to 1.74% during the quarter (see footnote 2). As a result, the Bloomberg Barclays U.S. Aggregate Bond Index, was down -3.37% in Q1, which is its worst quarter since Q3 1981 (see footnote 2). Still, since its inception in 1976, the U.S. Aggregate Bond Index has only experienced 3 negative years, so perhaps the worst for bond investors is behind us (see footnote 2). Also, the negative returns for bonds shouldn’t be a surprise after strong performance over the last several years. The equity market likewise started pricing in strong economic growth, as leadership changed from large cap growth, technology related sectors to smaller sized more cyclical, value-oriented sectors like energy, financials, and industrials in Q1 (see footnote 2). Broader equity indices are solidly in positive territory after Q1 with the S&P 500 up 6.18%, which puts it in the top 25% of all Q1’s dating back to 1926 (see footnote 2). Below is a performance summary of key asset classes and sectors for the quarter (see footnote 2).
Still, there are several concerning aspects from our view including high levels of optimism, extended valuation levels and potential for yet higher interest rates and inflation. Below is a review of each:
- Excessive optimism: Some examples from Q1 2021 are the recent large price and trading volume increases in vehicles like margin debt, Bitcoin, Tesla, IPOs, SPACs, long call options, non-fungible tokens, GameStop, and the blow up of family office Archegos that had taken on massive leverage in names like Viacom and Discovery. These examples potentially point to excessive optimism on the part of investors from our view. This type of price and trading volume action tends be a contrarian indicator based on our experience, and should give us patient, longer-term investors some cause for concern. Situations like these typically lead to quick bouts of volatility that shouldn’t surprise us during the balance of 2021.
- Extended valuation levels: The price of the stock market relative to fundamental measures like earnings and cash flow remain a concern for our team. Using the S&P 500 as an example, the forward 12-month P/E is around 22 with a 25-year average around 16.5 (see footnote 2). The Cyclically Adjusted P/E ratio (CAPE) is around 36 compared to the 25-year average around 27.5 (see footnote 2). The Price/Cash Flow ratio is near 16 versus a 25-year average closer to 11 (see footnote 2). What is different now is that interest rates are being held at extremely low levels by the Federal Reserve compared to history. Higher multiples may be justified relative to longer-term historical metrics given this. How much so is the key question and the rise in rates in Q1 2021 demonstrated this. As the economy fully recovers from the virus induced recession, earnings may be able to grow into these higher multiples. However, as we will outline shortly, if economic growth expands too rapidly in 2021 given all the stimulus, longer term interest rates and inflation expectations may continue to rise as they did in Q1. If so, these high multiples compared to history may begin to look expensive to investors. The bottom line from a valuation perspective is that while metrics are high relative to history, they may not be too high yet given where interest rates are. Valuation data is likewise never a good tool to use for considering potential shorter-term market movements from our view. However, we think a major assumption implicit in current equity market prices is that longer-term interest and inflation rates will remain controlled and near Fed targets. We worry strong economic growth in 2021 may not fully support this assumption.
- Higher interest rates and inflation: We also worry that investors better “be careful what they wish for” with stronger economic growth. Given all the stimulus measures mentioned and potential pent up demand as people, goods, services and capital start to flow more freely, we think there is a decent chance the economic porridge may get a bit too hot potentially leading to higher inflation expectations and thereby continued higher longer term interest rates. We saw this and its impacts in Q1 on growth stocks and bond markets. More of this could set up the valuation dilemma already described. If inflation gets a bit too warm for the Fed’s liking in the back half of 2021, it could put them in the uncomfortable position of bringing up the terrible “T” word…Taper. Any tapering of the asset purchases described earlier or language changes around reducing the size of the Fed’s balance sheet could lead to a “taper tantrum” as we witnessed at the end of 2018. A turning of the page to a newer chapter in monetary policy could have profound implications on asset prices. It’s a top concern for us for the rest of 2021.
Balancing the ledger between the potential opportunities and challenges, it strikes our team that not being too far out on a limb in any direction makes sense as we start Q2 2021. This is the same conclusion we drew to start the year. As such, most Sequoia strategies are broadly balanced (neutral) relative to equity/fixed income targets, with modest tilts toward US higher quality equities and lower fixed income duration than broad indices. For example, our 70% equity/30% fixed income strategies are generally in-line with these “neutral” points (i.e. not materially greater than or less than 70% equity). Also, within fixed income allocations, several strategies hold managers that have flexibility to adjust duration and look for yield globally where interest rates may be more attractive. This mix may change as we learn more about how global economies emerge from the pandemic. In particular, equities in Europe and many developed nations may offer compelling valuations relative the U.S. as they reopen their economies. We are researching these aspects presently. Also, we expect to simply rebalance many of our strategies in early Q2 2021, so don’t be surprised to see transactions in your accounts.
As investors, we want to remain patient and disciplined until we better understand how well the U.S. and the world emerge from the pandemic. For now, we are on guard for the U.S. economy to potentially be quite strong in 2021, which may create questions about the Federal Reserve’s highly accommodative monetary policy. The large-scale fiscal stimulus efforts may also create questions about tax policy. Both could have significant implications for asset prices as we navigate the rest of 2021. For now, we think investors should maintain diversified portfolios with sufficient equity exposure by maintaining focus on “Don’t fight the Fed, the fiscal authorities, or the vaccines” as they remain the dominant forces supporting markets for now.
Sources: 1. https://covid.cdc.gov/covid-data-tracker/#vaccinations 2. Bloomberg