By Darren Nyce, CFA
Senior Research Analyst, Castle Investment Advisors®, LLC
Let’s talk about cake. Specifically, the kind of cake involved in celebrating the passing of a year. When a baby turns one year old, that is the time most kids get to eat cake for the first time. The sheer joy and delight that comes over them as they taste the sweet treat is an amazing experience for the child and brings smiles to those who watch this event, despite the inevitable messiness that goes with it.
Another tradition is for a couple to freeze a portion of their wedding cake, then break out the cake and eat it as a part of their one-year anniversary celebration. My experience is that the reaction to eating this one-year-old cake is completely different from a one-year-old eating cake. The expectations are high, the anticipation builds, and then you bite into a dry, flavorless slice and are immediately disappointed and facing a plateful of unmet expectations.
During the first quarter of 2021, we passed the one-year mark of the emergence of COVID-19, with its terrible human tragedies, quarantine-induced economic shutdown, and the corresponding plunge in the investment markets. When we look at where we are one year later, most have the reactions of both types of cake-eaters. On one hand there is the frustration of unmet expectations that we still have to wear masks, many are still unemployed, we still can’t vacation as freely as we’d like, and much of life is still not “back to normal.” But on the other hand, there are plenty of reasons to smile. Science has made tremendous progress in developing a vaccine, and we are on a path to herd immunity, businesses are adapting, the overall economy is doing quite well, and our investment portfolios have completely recovered (and then some) as the stock market has moved to all-time highs.
1st Quarter 2021
Looking at the market numbers updated through the end of Q1 (see chart below), the one-year stock returns are astonishing. Of course, these are in the context of coming a year after the pandemic-induced selloff in March 2020. For the quarter, all of the S&P sectors were positive, with energy leading the way, up 31%, while Technology, which was the 2020 leader, was up just 2%.
|Index|| 1st Qtr 2021
|Russell 2000 – Smaller Companies||12.7%||94.8%||14.8%||16.4%|
|MSCI EAFE – International||3.5%||44.6%||6%||8.8%|
|Barclays US Aggregate Bond||-3.4%||0.7%||4.7%||3.1%|
Notice that the only negative in the previous chart is the quarterly return for bonds. Keep in mind that the prices of bonds you own go down when interest rates rise (for example, the price of a bond paying 3% is worth less when a buyer can go buy a similar bond paying 4%). The yield of a 10-year Treasury Bond is represented by the blue line in the chart below. While a yield around 1.5% doesn’t seem like much, the rise from a level below 1% at the beginning of 2021 is significant and is the reason bond prices have declined during the quarter. Though the movement of interest rates is very complex, the most likely causes for this move are concerns about higher deficits and higher inflation.
Source: Bloomberg and Touchstone Investments
Should you be concerned about this trend continuing? We suggest, only a little – or better yet, rest assured that this is something we are watching on your behalf. As long as the interest rate sensitivity (the investment word is duration) is lower than the time you plan to hold a bond portfolio (typically decades), your bond portfolio will actually benefit from rising rates in the long run. This is true because the portfolio will generate more income thanks to the higher rates than it will lose due to price decline, even though from time to time you see a lower value for bonds on your monthly statement.
Economic reports have generally been quite positive.
- Retail Sales have been strong.
- Interest Rates remain low, with the Federal Reserve signaling their intention to keep it that way for quite a while.
- This benefits those wanting to start a new business or those wanting to expand an existing one.
- Congress has approved an additional $1.9 Trillion in stimulus payments – in addition to stimulative efforts that were made last year.
- A combination of demographics, low-interest rates, and the effects of a pandemic has caused a boom in the housing market.
- The Unemployment Rate has declined, though not to pre-crisis levels, and jobless claims remain relatively high.
- Inflation has started to trend higher, though most economists insist this will be temporary (If you hear any reports on inflation these days, it is unlikely that the report will conclude without you hearing the buzzword “transitory”).
- Two risks that could change the trend of economic growth are:
- What if inflation is not “transitory”?
- Will additional strains of the COVID-19 virus cause renewed public health concerns?
We try hard to avoid making predictions and stick to analyzing data, but it is interesting to hear what other leaders say about their expectations for the near future (source @TheTranscript_)
“I have little doubt that with excess savings, new stimulus savings, huge deficit spending, more QE, a new potential infrastructure bill, a successful vaccine and euphoria around the end of the pandemic, the U.S. economy will likely boom…This boom could easily run into 2023 because all the spending could extend well into 2023.” – JPMorgan Chase (JPM) CEO Jamie Dimon
“We feel like we’re at a place where the economy’s about to start growing much more quickly and job creation coming in much more quickly…I’d say that we and a lot of private-sector forecasters see strong growth and strong job creation starting right now. So really, the outlook has brightened substantially. ” – Federal Reserve Chair Jerome Powell
“Consumer excitement and optimism is returning in ways it hasn’t since well before the pandemic, and we’re seeing a denim resurgence as more people are going out.” – Levi Strauss (LEVI) CEO Chip Bergh
While the stock market has had a great recovery over the past year, it does currently face some significant headwinds, despite an economy that seems poised to grow.
- Valuations are high (see the chart below from J.P.Morgan.)
- Though the Forward P/E has come down a little as earnings have been outpacing expectations.
Source: FactSet, FRB, Robert Schiller, Standard & Poor's, Thomspon Reuters, J.P. Morgan Asset Management.
- Higher interest rates would be a threat to stocks that have risen due to optimistic sentiment.
- Corporate tax increases could be a drag on company earnings.
Biden Tax Reforms
Some have expressed great concern about what impact the proposed tax reforms might have on the stock market. We will give a brief overview, but we caution against over-reacting as political wrangling will likely lead to an implementation that is different than the proposals.
- Aside from any reforms, the outlook for earnings appears bright and the additional infrastructure spending is likely to offset some of the tax hit.
- In 2017, corporate taxes were cut by 14% from 35% to 21%; the end result of this was an increase in earnings of about 10%.
- President Biden’s proposal would raise these taxes halfway back, to 28%.
- Of course, none of these changes happen in a vacuum, so drawing straight-line conclusions is difficult. This would likely have a bigger impact on pharmaceutical and biotech companies – due to their tendency to book profits in tax havens - and less on companies in the energy, industrials, and financials sectors.
- Goldman Sachs has estimated that this would cause a 3% hit to 2022 earnings.
Our advice, as always, is to keep the big picture in mind; markets have done well in all kinds of taxation environments and have tended to reward those who stay the course. Small adjustments to your long-term plan are appropriate if they help you sleep better, but major changes are really hard to time correctly and usually end up doing more harm than good. Regular discussions with your financial team will help make sure you remain on track to meet your goals regardless of what is driving the current headlines.
Changes at Castle
As all of our clients already know, we are pleased to announce that the team at Castle will be joining forces with the team from Creative Planning from Kansas City. We expect this to result in an even greater experience for our clients as we tap into the resources and offerings that Creative has at its disposal such as an accounting team, a trust company, a legal team, access to additional investment products, and other services we will be sharing with you. Our team in Indianapolis will remain committed to the personal relationships that we have built with you over the years. Our pledge is to continue to keep your best interest at the forefront of our efforts as we complete this merger. If any questions come up during the process, please reach out to us using the same phone number or email addresses as always. Here’s to a great new chapter of our journey together!
Tax, legal, and estate planning advice contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation. This article was prepared for informational purposes only and does not constitute an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein. Information presented does not involve the rendering of personalized investment advice, but is limited to the dissemination of general information regarding products and services. It should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Any strategy discussed herein may not be suitable for all investors. Before implementing any strategy, investors should confer with their financial advisor. No current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels.