As economies around the world begin to reopen, markets rallied dramatically, with the focus shifting from fear to optimism and the strength of the coming global recovery. Equity markets extended their gains in the first quarter of 2021, but were volatile in a backdrop of U.S. political turmoil and continued COVID-19 uncertainty.
The new U.S. administration finalized a $1.9 trillion American Rescue Plan Act, consisting of direct payments to individuals and families, additional unemployment benefits, funding for state and local governments, and funds for vaccinations and testing. As longer-term bond yields rose, reflecting U.S. monetary and fiscal stimulus and rising inflation expectations, the Federal Reserve continued to advocate for extreme policy accommodation. Higher levels of personal savings and the latest stimulus will likely continue to bolster personal expenditures. The employment rate remains a drag on growth as U.S. job gains lag the recovery, and unemployment is expected to decline through year-end.
TRANSITORY TRENDS: ROTATION & RATES
Late last year, investors began to favor areas of the market that were most exposed to a recovery and most debilitated by the pandemic, most notably cyclical companies found in the financials, energy, and industrials sectors.
In the meantime, price pressures are building as the demand recovery is creating global bottlenecks and supply constraints in semiconductors and certain raw materials. Strong U.S. housing demand has also driven up house prices and transaction and mortgage rates.
Higher interest rates add to the uncertainty at a time when government debt is at record levels and weigh on equity valuations. We believe inflationary fears will prove transitory as the recovery should normalize once economies reopen in a sustainable manner and as the stimulus effects fade. We believe the rise in bond yields reflects expectations of more normal levels of growth to come.
SECULAR TRENDS: INNOVATION & DIGITAL TRANSFORMATION
The pandemic has accelerated the adoption of digital technologies by several years. Companies are investing in innovative technologies to remain competitive in this new environment across multiple fronts: tech-heavy capital expenditures; e-commerce strategies; enterprise cloud transitions; direct-to-consumer business models; and software applications. We believe large, global-oriented total addressable markets provide ample runway for long-duration top- and bottom-line growth, with many disruptive trends expected to double over the next three to five years. Historically, earlier stages of mass adoption have spurred more innovation, greater ease of use, and an expansion of the ecosystem, which in turn has kept the virtuous cycle spinning with yet greater adoption.
Cyclical stocks performed well during the quarter as investors favored companies worst hit by the pandemic amid rising expectations that the global economy will reopen this year. Small-cap companies were notable outperformers due to their greater exposure to U.S. economic activity compared to large multinational firms. The rotation has boosted valuations of economically sensitive companies and reduced the earnings multiples of secular growth companies.
We are encouraged by the continued strong results of companies, especially those in the growth sectors of the economy, like information technology and communication services. We believe that the moderation in valuations in the first quarter improves the outlook for share price appreciation, adding to the attractiveness of the superior growth characteristics that we seek over an extended investment time horizon.
In 2021’s first quarter, the health care sector of the S&P 500 Index rose 3.2%, underperforming the overall Index, which advanced 6.2%. Even though vaccines for COVID-19 were developed and approved remarkably quickly, it may still be several months before doses have been distributed and widely administered—the likely prerequisite for a broad-based recovery in confidence and activity.
We believe the pandemic could have a permanent and salutary impact on the health care sector. The past several months have highlighted inefficiencies within the system and the serious implications of administrative mismanagement. At the same time, there has been phenomenal speed of discovery and multiple modalities available within the biotechnology, life sciences, and health care technology industries to address unmet medical needs. As a result, many companies may be able to penetrate their total addressable markets at accelerated rates.
The S&P 500 Financials Index returned 16.0%, versus 6.2% for the S&P 500 and was one of the best-performing sectors of the market, second only to energy. The tide turned for the sector in November of 2020 on news of a COVID-19 vaccine. Growing anticipation of an economic recovery that signaled better credit conditions, rising interest rates, and the passage of a second stimulus plan fueled the sector’s performance in 1Q21. The current environment is favorable for universal banks and brokers as the capital markets are very robust and expenses well-controlled. Also, higher interest rates (especially with a steeper yield curve) translate into higher interest revenue and earnings for the regional banks, though this is largely priced into stocks.
While the end of the pandemic and return to pre-2020 growth levels are starting to come into view, the timeframe for a full recovery is still unknown due to lingering effects on consumer and business confidence and balance sheets. Many of the macro concerns that plagued the sector before the pandemic are still in place. The Fed has signaled that interest rates will remain at depressed levels for the foreseeable future, and there is still no certainty around longer-term higher economic growth. As such, the sustainability of the rally in the sector is uncertain.
In 1Q21, the Alerian MLP Index was up 22.0% and the Alerian Midstream Energy Index (which includes not just MLPs, but a broader group of midstream infrastructure companies) gained 20.9%. The beaten-down sector continued to rally on positive vaccine news, an improving macro environment, and the anticipation of returning to normalized levels of supply and demand in a post-pandemic world. Many midstream companies took decisive measures to conserve cash and “right the ship” during the global pandemic by reducing capex and growth spending and improving cash-flow metrics—a trend we expect to continue throughout 2021. Added cost reductions and increased asset optimizations should continue to help reduce debt levels and fortify balance sheets.
Improved fundamentals are finally starting to be reflected in stock prices but may give investors pause given uncertainty in the exact timing of a full reopening of the U.S. and global economies. As economic activity continues to slowly ramp up, stocks should begin to price in not only the short-term economic recovery bounce, but also the long-term positive benefits from the significant transformational corporate reform that has occurred over the past few years. With the Biden administration unlikely to make permitting easier for new pipeline projects, we believe the value of existing infrastructure could also increase as a result, and we would not be surprised to see M&A and industry consolidation occur over the next 12 to18 months.
Underperformance for the utility sector continued in 1Q21 as market sentiment shifted dramatically toward economically sensitive sectors expected to benefit from a global economic reopening and rebound in economic activity. In addition, a spike in interest rates has caused investors to question the attractiveness of utility stocks amid a higher-rate environment.
We continue to find the sector attractive given the (still) lower-than-average interest rate environment, the sector’s predictable fundamentals, and its ability to provide stable dividends amidst macro uncertainty. We believe it should also provide earnings growth above its historical 3-5% EPS growth given the potential growth opportunities from renewable energy investments.
Risks— Investing involves risks. Some investments are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, and political and economic uncertainties. Emerging and developing market investments may be especially volatile. Emerging markets are countries that are beginning to emerge with increased consumer potential driven by rapid industrial expansion and economic growth. Investing in emerging markets is very risky due to the additional political, economic, and currency risks associated with these underdeveloped geographic areas. Investments in securities of growth companies may be especially volatile. Due to the recent global economic crisis that caused financial difficulties for many European Union countries, eurozone investments may be subject to volatility and liquidity issues. Value investing involves the risk that undervalued securities may not appreciate as anticipated. It may take a substantial period of time to realize a gain on an investment in a small or midsized company, if any gain is realized at all. Diversification and asset allocation do not guarantee profit or protect against loss.
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1047435-00001-00 Ed. 4/2021