2021 Q1 Quarterly Report

Economic Commentary

Accelerated vaccine rollout in the US has bolstered economic growth rebound forecasts for the reopening economy as we begin to enter the warmer months, which should also reduce the risk of virus transmission. Another $1.9T of fiscal stimulus in the form of COVID19 relief under the Biden administration has taken the expansionary baton from the monetary authorities at the Federal Reserve (Fed). The Fed has effectively lessened accommodative measures by not increasing their current program buying of $80B in US Treasuries and $40B of mortgage-backed securities per month, eliciting minor tantrums from US investors. Despite the slight uptick in volatility, the Fed has repeatedly reiterated its stance that the current pace of accommodation is appropriate, and that they will not be tightening financial conditions by increasing the benchmark federal funds rate prior to 2023, with the only caveat being unless there is a material and sustained upward acceleration in inflation.

Market-based measures for inflation, or the difference between nominal and real interest rates called break-evens, have been rising during the quarter due to expectations for a continued rebound in economic activity. The 5-year breakeven measure has increased steadily and now stabilized above 2.5% (Chart below), meaning that investors in 5-year Treasuries are now expecting inflation to average that amount over that time-frame, the highest level since 2008. This contrasts with the most recent (February) official measures for the Consumer Price Index and the Personal Consumption Expenditures Price Index showing year-on-year increases of 1.7% and 1.6%, respectively, and only 1.3% and 1.4% when adjusting out volatile food and energy prices. These measures will likely begin to show large year-on-year increases as new data begins to compare against the heart of US lockdowns last spring and early-summer, reflecting realized prices paid due to bottlenecks in raw material global supply chains and pent-up demand from confident consumers bolstered by high savings rates and direct checks from the government.

The Fed’s insistence on boosting prices may prove to be a larger burden on the other side of their so-called “dual mandate”, with the official unemployment rate still at 6.0%. With many Americans likely unable to absorb increased cost of living expenses despite the extension of expanded unemployment benefits, the current situation may exacerbate the K-shaped recovery. Highlighting this point is the fact that home prices have risen by over 11% in the last year. This is the fastest rate in 15 years, according to the S&P CoreLogic Case Shiller Home Price Index, and unusual during a recession as the pandemic and record low mortgage rates fueled furious buying in undersupplied suburban markets. Estimates vary widely for when the US economy may again approach something close to full employment, and post-pandemic dislocations are a tough bogey for monetary authorities, whose policy tools tend to be broader and less focused than what may be achievable from fiscal authorities. Recent news from the Biden administration shows that they are wasting little time in those efforts, announcing a ~$2T infrastructure bill focused on green energy and jobs. However, the announcement also included provisions to increase corporate taxes, so the situation is becoming increasingly ambiguous in terms of the net effect on the labor force and thus the broader economic context.

5-Year-Inflation

Chart created by Hanlon with data provided by Federal Reserve of St. Louis. Data as of 03/31/2021.

Market Commentary

Broad US equity market indices delivered strong returns in the 1st quarter of 2021, with the S&P 500 Index gaining nearly 6.2% and the Dow Jones Industrial Average returning 8.3%. The real story of the markets happened under the surface, however, as a rotation from growth continued into value as economic reopening boosted profitability for traditional pro-cyclical sectors like financials and industrials, while interest rate increases diminished justification for historically high valuations in the technology space. The technology-heavy Nasdaq Composite Index finished the quarter nearly 2.8% higher, highlighting that it was by no means a blood bath in the space, though the relative performance of equities who benefit from a broader economic reopening improved market breadth to a more sustainable path going forward.

Small-cap and mid-cap US equities continued their outperformance from the end of 2020, also due to optimism for economic re-opening. An abundance of liquidity in markets as well as a boom in retail investment also buoyed certain investments which had been severely impacted by the pandemic and became short targets by hedge funds. The small-cap focused Russell 2000 Index finished the 1st quarter with a 12.7% gain despite pulling back nearly 6.0% in the back half of March.

Developed international equity markets ended the quarter with solid returns while central banks in Europe and Japan kept their foot on the expansionary pedal. Europe has had a harder time containing the spread of the COVID19 virus, causing ongoing demand concerns and renewed regional lockdowns. China, on the other hand, has begun to reduce accommodative measures, taking the wind out of the sails of equity market strength for broader emerging markets during the quarter. The US dollar strengthened significantly during the quarter, usually a double-edged sword for emerging market performance.

1st Quarter Bond Performance

Long-Term_US Treasuries

Chart created by Hanlon with data provided by Investors FastTrack. Data as of 03/31/2021. Long-Term US Treasuries is represented by the iShares 20+ Year Treasury ETF (TLT), IC Corporate Bonds by iShares Investment Grade Bond Corp Bond ETF (LQD), and HY Corporate Bonds by iShares iBoxx US High Yield Corporate Bond ETF (HYG).

Effective tightening in US markets via rising rates during the quarter rivaled the so-called “Taper Tantrum” in 2013, as growth and inflation expectations increased benchmark Treasury rates, at times quite quickly, during the quarter. Market participants were left wondering at what point the move would start to negatively affect financial conditions, and thus force the Fed to intervene by targeting certain maturities with their current bond buying to slow down the pressure on bond prices, which have become concerningly correlated to risk assets. Fed Chairman Jerome Powell addressed the issue publicly by reassuring that they are constantly monitoring financial conditions, and the group is comfortable with the recent developments and that markets seem to be functioning well. It seems that the recovery is regarded as strong enough so that the Fed could leave that potential tool in the toolbox, for now.

The effect on the bond market during the quarter was most severe in sectors with the most interest rate sensitivity, or duration, which is mostly concentrated in the longer, 10 to 30-year Treasury securities. This is emphasized by the -13.9% return from the iShares 20+Year Treasury ETF (TLT) during the quarter. Investment grade (IC) corporate bonds were also negatively affected by the rate rise, though to a lesser extent due to the extra cushion provided by additional interest offered to account for credit risk, generally quoted as a spread above a similar maturity Treasury. Sub-investment grade, or high yield (HY), corporate bonds outperformed due to an even greater, though historically tight, amount of spread cushion than broader bond indices, which include mostly or all investment grade, highlighting that the move in interest rates is not linked to increased credit concerns at this time.

Commodities continued their momentum from the end of 2021, with oil prices reaching their highest levels since late 2018 before retreating somewhat due to waning optimism for European demand. OPEC has surprisingly continued self-imposed supply limits, moderating global supply, and American production remains depressed since the height of the pandemic lockdowns. Other raw materials, including copper and lumber, also increased in price during the quarter amid strong manufacturing demand and assumptions for rebounding global growth.

Closing Remarks

Markets continue to price in optimistic forecasts for a continued global rebound, as huge amounts of stimulus-fueled liquidity contribute to eyebrow-raising valuations in some corners of financial markets. These will likely correct, hopefully without taking broader markets with them. It is yet to be determined whether monetary authorities have the will to limit the proverbial punchbowl that has contributed to certain excesses, though they may be forced to do so sooner rather than later.

Market breadth, basically a broader participation of stocks, has continued to improve however, signaling a healthier recovery may be looming, but skittishness of market participants with indices near all-time highs and historically high correlations between stocks and bonds are cause for concern.

We will continue to focus on avoiding pitfalls where we can, persevering on our mission to manage your portfolio(s) with a disciplined and emotionless investment approach. As always, we will be guided by our principles of Passion, Integrity, Vision, and Care.

Thank you for the opportunity to be of service and we hope that everyone stays healthy and positive in these trying times.


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