First Quarter 2021 Investment Commentary
Keeping a balanced approach is always wise. Here is our comments for the first quarter of 2021.
- A year into coronavirus, the light at the end of the tunnel?
- The new administration takes office, with Democrats in the majority in both House and Senate
- Upward sloping yield curve with short-term rates near zero but longer-term rates seeing an increase
- Vaccination efforts accelerating across the globe; economists projecting an increase in economic growth
- Fed strongly committed to achieving goals, not yet ready to talk about tapering
- Consumer confidence is strong
Reasons for concern:
- Vaccine rollout is inconsistent across the globe
- We could see unexpected inflation, forcing the Fed’s hands earlier than anticipated
- Recovery is far from over, obstacles can get in the way
Quite a year
Keeping a balanced approach is always a hard thing to do when certain sectors perform better. It is hard to believe that we have been dealing with Covid-19 for over a year now. Remember where we were at the end of the first quarter of 2020? The longest bull market run in history had ended, we experienced the fastest bear market in history, and we were all searching for toilet paper. Since then, we have received timely and sizable amounts of stimulus, in the forms of fiscal and monetary policy. And yes, the last 12 month returns shown in the graph on the previous page are correct; it has indeed been quite a year.
We have continuously spoken about this from the perspective that Covid-19 is a health crisis that created an economic crisis, which really does make it different from previous downturns. And there are a lot of encouraging signs, though it would be too early and irresponsible to give the “all-clear” signal. In early November 2020, we received the first news that vaccinations were effective in global trials. Since then, the rate of vaccinations globally has steadily increased, though is still very inconsistent from country to country. Interestingly, the inconsistencies aren’t even consistent across developed and emerging countries.
U.S. equities had quite a strong first quarter, which only added to the results of the previous several months. In fact, small-cap equities, as represented by the Russell 2000, gained 13% for the last three months and 95% over the last 12. Part of what makes this run so astonishing is the extent to which we saw small caps lag large-cap stocks in 2020. In particular at the early stages of the pandemic, only to see a meaningful reversal in such a short time period.
Over the last quarter, international small-cap stocks outperformed their large-cap counterparts while emerging market stocks trailed both.
From a country perspective, the countries with the largest weight in the MSCI EAFE index (Japan, UK, France, Germany, Switzerland) all underperformed the US on a relative basis. The Netherlands had the highest return (11.8%) but comprises less than 5% of the index. In the emerging markets, China remains the largest country exposure in most emerging market indexes but was flat (0.0% return) for the quarter. Other countries with larger exposures in emerging market indexes performed relatively well. Taiwan (10.7%) and India (6.9%), though these returns were still not enough to pull the overall index ahead of either US or developed ex-US equity indexes for the quarter.
Global REITs, as represented by the Dow Jones Global Select REIT, generated a 7.7% return for the quarter, with U.S. REITs (10.0%) outperforming non-U.S. REITS (3.1%). Over the last 12 months, REITS have bounced back but not nearly as much as equities have in general.
Obviously, Covid-19 played a major role in the experiences of various REITs throughout the last year. With lockdowns in place and most people not traveling too far from home, it makes perfect sense that we saw significant declines in REIT sectors where social distancing is quite difficult. This includes sectors such as lodging, shopping centers, and health care facilities (e.g. nursing homes). However, it is important to remember that REIT sectors are quite diversified.
Global Fixed Income
Unlike equities, most fixed income indexes actually declined for the quarter, and Treasury indexes have even moved into negative territory over the last 12 months. As signs of a strengthening economy continued, we saw a steepening of the yield curve as Treasuries sold off, in particular on the intermediate and longer portions of the yield curve. As we know, yields and prices move inversely with one another, hence the negative returns across Treasuries.
As we think about inflation, TIPS (Treasury Inflation-Protected Securities) are thought of as the best hedge against inflation as the securities are tied to the CPI, a broad measure of inflation. Some of the reasons why some inflation protection and an allocation to TIPS may be warranted today include:
- The Fed has stated their inflation target is an average of 2% and not a 2% target as it previously was, which means inflation could be above 2% for a while.
- A surge in economic activity could lead to an inflation surprise. On the flip side, there are also reasons why an investor may choose not to hedge against inflation via a TIPS allocation: 1) for investors that have substantial equity positions, it is believed that equities will outpace inflation over time, 2) TIPS perform relatively poorly when real yields rise.
- TIPS are seen as being tax-inefficient.
Tradeoffs in Bonds
In previous quarters, in order to generate more return, investors need to assume more risk. In fixed income, that means either extending duration or lowering credit quality. There are tradeoffs that have to be weighed very carefully before implementing either strategy. From a duration standpoint, extending duration too far out can be a risky move in a period of rising rates. Similarly, lowering credit quality means investing in high yield, or junk bonds, which generally correlate much more with equities and therefore don’t provide the diversification benefits we expect from fixed income.
Like Treasuries and corporate bonds, municipal bond returns mostly fell during the quarter with only short-term bonds eking out a slight, positive return.
We continue to view fixed income as a method of reducing overall portfolio risk (as measured by standard deviation), given that equities are expected to have much higher volatility. Our portfolio’s focus will continue to be on high-quality bonds with an emphasis on short to intermediate-duration government and corporate bonds, where default risk has historically been relatively low. For some investors, muni bonds are attractive for their tax-free income.
This a summary of a full report you can receive if you request it.
Disclosure: East Bay Financial Services, LLC and Clarity Wealth Development have an arrangement whereby Easy Bay Financial Services, LLC provides model recommendations on a consulting basis to Clarity Wealth Development. Clarity Wealth Development maintains full discretion and trading authority over its clients’ accounts.
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