Investors will be pleased to see the benchmark S&P 500 finish 5.77% higher to close the 1st quarter. That figure masks some sharp short-term swings both up and down. The bond market played its part in those gyrations as the yield on the 10-year U.S. Treasury Note nearly doubled to 1.75%. Higher interest rates mean future earnings are discounted more today, though stronger economic growth moving forward will likely lead to higher expected and actual earnings that could boost share prices. After looking optimistically toward an eventual economic reopening, markets are now pricing in the facts of an actual reopening as vaccines are broadly distributed in the U.S. and social mobility increases. Heightened market volatility is to be expected at this stage as each major economic release reveals either progress or regression along a path to widespread economic recovery. Investors may feel they need a seatbelt, but economic momentum is building.
The Federal Reserve projects 6.5% U.S. economic growth during 2021. If correct, that clip would represent the best year-over-year G.D.P. increase since 1984. Recent fiscal stimulus will hit the economy in late March and early April. This latest salvo from Congress and the Fed’s extremely supportive policy stance set the stage for an economic surge heading into the summer. Science will provide additional tailwinds as mass vaccinations likely reduce the need to limit activity for safety reasons. Economists project above-trend growth for 2021 and into 2022, with the strongest phases likely in the 2nd and 3rd quarters of this year. The hope is that such growth becomes a self-reinforcing cycle where strong growth begets strong growth. The pronounced move higher in bond yields rightly reflects the outlook for accelerating economic growth, but some investors express concern that such rapid growth may spur inflation. Inflation will probably be higher than in 2020, but as we discussed in recent blog post, multiple disinflationary factors make concerning levels of 1970s-style inflation unlikely.
The economically-sensitive Energy, Financials, Industrials and Materials sectors led the way in S&P 500 performance as markets anticipate the economic acceleration that will likely accompany a full-on economic reopening during 2021. Financial markets typically run ahead of the actual economic data, but it’s quite typical for these Cyclical sectors to perform well when the smell of growth is in the air. Financials benefited from long-term interest rates rising relative to the short-term rates banks pay on deposits. Materials and Industrials are seeing demand pick up as delayed projects rumble back to life. Rumors of a large federal infrastructure package from Congress also buoyed these areas. Communication Services also performed strongly, as advertising budgets will likely increase in 2021. Real Estate is typically a defensive sector, but the potential reopening boost to malls and hotels aided performance during the 1st quarter. After an extended period of market leadership, Information Technology shares lagged as investors saw opportunities to buy near-term growth in sectors with bargain valuations as the tide of broad economic expansion raises all boats. The long-term tailwind of broadening digitization in most every aspect of life still paints a compelling narrative for Tech, but in 2021 growth will be prevalent in additional market sectors.
As a forward-looking mechanism, the stock market has priced in some of the current good news. Widespread vaccination can help increase economic activity as industries severely hampered or literally shut down by mobility restrictions and social distancing can reopen. These developments are positive, but the question becomes whether economic growth and corporate earnings will deliver on or exceed expectations. Some economists project U.S. G.D.P. growth could reach double-digits, though the consensus expectation is more modest. Anecdotally, there is pent up demand for the travel and leisure activities foregone in the past year, and U.S. households have never had stronger balance sheets coming out of a recession. From an investor’s perspective, earnings will have to deliver. Recent quarters have seen analysts vastly underestimate corporate earnings and profitability under trying circumstances. Given the much more favorable evolving conditions, earnings releases may yet surprise to the upside again as growth accelerates.