The Trend Continues
The positive trend of the U.S. stock market continued in the first quarter with the major indices recording respectable gains. This rally was likely fueled by the $900 billion in stimulus passed in December 2020, the additional $1.9 trillion in stimulus passed in March, along with a significant drop in Covid cases nationwide. It is interesting to note that one of the sectors to lag the overall market was technology. This may not have been surprising given its strong outperformance during 2020 and the significant rise, in percentage terms, in interest rates during the quarter. As a generalization, technology companies are long-duration assets whose long-term cash flows are very susceptible to changes in interest rates. With the yield on the 10-year Treasury note nearly doubling during the quarter, many technology stocks struggled as investors rotated into areas that benefit from rising rates such as financials and industrials. As we look ahead to the rest of this year, we are paying attention to the following.
Vaccinations and Reopening
The U.S. is one of the global leaders in vaccinating its populace. This has led to a dramatic drop in the number of new infections as well as hospitalizations. It seems quite possible that all Americans who desire to be vaccinated will have the opportunity by June 30. This should drive a further reopening of the U.S. economy as restaurants increase their capacity, travel and leisure activities resume, and workers begin to slowly return to their offices. The reopening is likely to be turbo-charged by the additional discretionary income many Americans will have just received from the latest round of stimulus.
President Biden has put forth a $2.3 trillion infrastructure plan. Not surprisingly, this plan was met with a loud Bronx cheer from Republicans. Even so, if Democrats can avoid any defections from their side, the plan may become law. On Monday April 5, 2021, a top Senate official ruled that Democrats could use the fast-track budget reconciliation process for a second time this fiscal year, potentially paving the way for them to move within months to push through the plan despite Republican opposition. If so, this additional stimulus on top of the previous $2.8 trillion over the preceding 9 months, coupled with the general reopening of the economy, could result in some very strong economic growth numbers later this year.
President Biden is proposing an increase in corporate taxes to fund his infrastructure plan. Specifically, he favors raising the corporate tax rate from 21% to 28%, thereby partially reversing the tax cuts passed in 2017 under former President Donald Trump. If corporate tax rates are increased, this will on margin negatively impact corporate earnings. A reduction in corporate profitability given the generally rich valuation of the overall stock market could pose a headwind later this year.
Federal Reserve Policy
The U.S. Federal Reserve (the Fed) has continued to message that their policy will remain very accommodative to promote a full recovery from the pandemic. For the moment, this translates into $120 billion in asset purchases per month while maintaining a zero-interest rate policy on fed fund rates. If the economy begins to run a bit hot later this year, the Fed may be forced to begin to remove the monetary stimulus it has put into place. While stimulus is a net positive for short-term economic growth, too much of a good thing could lead to unintended consequences whereby the Fed has to reverse its policy resulting in a tightening of financial conditions. That type of environment, historically speaking, can be challenging to stocks.
As a generalization, the U.S. stock market is not cheap. While one may argue it is fairly priced based on current interest rates, multiple metrics indicate the U.S. market is trading in the top decile of its historical valuation range. This does not mean valuations must immediately compress, as rates may remain low for many years. If, however, the Fed feels compelled to act to slow the economy later this year, it is quite possible we could see equity valuations come under pressure.
Thankfully, there is growing optimism around the rate of vaccinations and the reopening of the U.S. economy. This, coupled with the ongoing federal stimulus and aggressive monetary policy from the Fed, within the context of historically low interest rates, has led to a short-term “goldilocks” scenario for the U.S. stock market and economy. But alas, nothing stays the same forever. We expect the environment to begin to change later this year as the Fed may become less accommodative to the markets and economy. As such, we remain focused on buying quality companies at fair prices and shunning companies that are egregiously overvalued and/or require the current environment to remain the same to justify their valuations.
We are grateful for the trust you place in us and remain committed to helping you achieve your financial goals.