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April 5, 2021
It appears fiscal policy has effectively bridged the income gap between massive job loss in the services sectors and the broad vaccine distribution that has hastened the reopening of the economy. First-quarter GDP should be strong despite February’s weakness caused by inclement weather across the country. Since lost production due to weather events is typically recovered in subsequent months, the markets generally ignored the slowdown, focusing instead on infection, hospitalization and vaccination rates.
Within the equity markets, cyclical sectors continued their end-of-year momentum, notably outperforming the more stable growth sectors. Excitement around impending economic reopenings is driving earnings-growth expectations and pricing for the more economically-sensitive areas of the market. In addition to value stocks outpacing growth, small and mid-cap stocks beat the large-cap indices. Overseas, the European economy contracted once again as rising infection rates led to renewed lockdowns. Despite the weaker economy, European equity markets performed well, with investors looking beyond these near-term issues to a broader reopening over the summer.
During the quarter, some large hedge funds’ high-profile struggles garnered much attention. Melvin Capital was caught in a classic short squeeze. It appears predominantly retail investors using social media bid up prices of companies with relatively weak business fundamentals, which caused steep losses in the hedge fund. Another incident occurred at the end of the quarter when Archegos Capital was forced to unwind highly-levered positions, creating significant losses for some of its lending banks. Investors are currently viewing these as isolated incidents, providing no systemic risk to markets and the economy.
A bigger risk to equity markets may be the sharp rise in bond yields and the steepening of the yield curve seen throughout the quarter. The yield on the 10-year Treasury note nearly doubled on heightened fears that strong economic growth would provoke inflation. The Fed viewed this spike as a sign of economic recovery and reiterated it would maintain its current policy until inflation rises more consistently above the 2% target.
The $1.9 trillion fiscal package passed in March on top of the relief provided at the end of 2020 should help drive strong economic growth for at least the next two quarters, with an expected 8% U.S. GDP growth rate for full-year 2021. We believe any inflation will be more cyclical than longer-lasting. Sufficient slack exists in the labor force, and employee productivity should improve thanks to capital spending on technology. Strained supply chains as reflected in a severe semiconductor chip shortage and worsened by the blockage of the Suez Canal should ease as production ramps up over the spring and summer.
Outside the U. S., Europe should emerge from its double-dip recession in the second quarter as its admittedly disjointed vaccination effort gains traction. Additionally, Japan appears poised to return to growth and full employment, fueled by the global economic recovery. The Chinese economy should settle back into its previous 5-6% growth path after having fully rebounded at the end of last year.
Record fiscal policies combined with the reopening of most service industries may fuel the greatest U.S. economic growth rate in years. While Fed policy should remain steady, the spike in longer-term bond rates could potentially impede equity returns, particularly in the high-multiple growth sectors. Markets will continue to focus on the economic recovery, with cyclical companies primarily experiencing a “V”-rebound in corporate profits. Consumer spending may slow in the near term due to higher oil and gas prices. Even so, higher personal income and savings rates should provide ample fuel for notable consumption over the rest of the year.
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