April 22, 2021
Dear Clients and Friends,
The first quarter marks one year since COVID-19 started making waves through our lives. It may be early to declare victory against COVID-19, but significant progress in that battle has been made this year. Between the vaccination efforts and the stimulus measures undertaken by governments and central banks, the US and world economies appear headed on the right track.
March 2021 saw the introduction of additional stimulus measures from the government, including stimulus checks and enhanced unemployment benefits. Preliminary talks also began on a bipartisan major infrastructure bill slated for later this year, designed to inject $2T into the US economy over a period of eight years. The Federal Reserve continued to reiterate its support for the financial system, vowing to keep interest rates low to encourage increased lending. The level of federal support has been unprecedented in this recession, with the amount of stimulus relative to GDP surpassing the support from the government over the last five recessions combined.
The first quarter saw periods of weakness for both the equity and fixed income markets, as inflation became a major point of focus. Bond interest rates rose sharply in the early months of 2021, leading to a reduction in bond prices. As the economy returns to full capacity, and with US consumers reaching $1.75T of excess savings due to stimulus measures, bond yields appear to be pricing in an increasing expectation of near-term inflation. Though the Federal Reserve has reiterated its commitment to allowing inflation to run higher than average before raising interest rates, equity investors have been concerned that higher-than-expected inflation could derail the economic recovery sooner than anticipated.
Despite worries over inflation, the economy continues to meet impressive milestones, including the unemployment rate dropping to 6.0%, just 2.5 percentage points higher than its pre-pandemic level in February 2020. And although weekly unemployment claims remain stubbornly high, this may be due in part to the current attractiveness of unemployment benefits relative to wages. Companies continue to exceed earnings expectations, and corporate balance sheets are flush with cash. Business formation applications have skyrocketed which could prove an important driver of job creation and GDP growth as the expansion unfolds.
Given the strong rally, concerns have surfaced regarding valuations and sentiment. The forward 12-month P/E ratio for the S&P 500 is 22.5, well above the five-year average of 17.8 and the 10-year average of 15.9. On a price-to-sales basis, the S&P 500 trades over 3 times sales, a level higher than the tech bubble of the early 2000s. Sentiment surveys from both individual investors and fund managers alike are showing extreme bullishness. This is confirmed by market action such as a disproportionate amount of Call options purchased relative to Puts, indicating significant investor confidence of additional upside in the short-term. When sentiment is heavily tilted towards one side (bullish or bearish), the market can be susceptible to volatility in the opposite direction.
We continue to monitor these and other concerns while maintaining an equity portfolio well-balanced and diversified across Growth and Value, Large and Small, and US and Foreign stocks. Portfolios also maintain a slight overweight to fixed-income securities to help dampen the potential of volatility over the coming quarter.
Overall, it is likely the US is at the tail end of its battle with COVID-19. The markets remain optimistic over the improving economic backdrop, and the US economy looks on track to stand on its own feet soon. COVID-19 still presents risks of course, and stocks may be due for a pause after such a strong run. Furthermore, while the rate of economic and earnings growth coming out of the pandemic-induced shutdown has been significant, investors may need to temper expectations going forward as we enter a more normal environment. Ultimately, the backdrop of improving economic growth, supportive fiscal and monetary policy, rebounding corporate profits, and improving COVID-19 trends are reasons for investors to be optimistic for the long-term.
As always, please feel free to reach out with any questions.
Gallacher Investment Committee