Q1:2021 — A Return to Value

The investment markets got off to a strong start in 2021 with a Q1 return of 6.2% on the S&P 500. Despite bearish warnings at year-end about stock market overvaluation, prices continue to trend higher.

The U.S. appears on track to reach a post-COVID era in the coming quarters. With the one-two punch of COVID vaccinations and federal stimulus, investors are filled with renewed confidence.

The best performing equity sectors this year have been energy, financials, and industrials. Strength in these traditional value sectors is a shift from the past leadership of technology and healthcare stocks. This may herald the beginning of a new equity phase following a five-year run for growth sectors.

The bond market also experienced a change of direction as interest rates began to creep higher. Although the Fed remains a staunch advocate for low rates through 2023, the 10-year Treasury yield has climbed to pre-COVID levels near 1.70%.

Key Events of Q1 and Projections

For investors, the most significant Q1 event was the monumental shift in control of the Senate from Republicans to Democrats, which will likely have far-reaching impacts on policy and legislation.

Tax policy will be a primary focus as legislators need a source of revenue to pay for the Biden administration’s agenda items and for COVID-19 relief legislation. All areas of the tax code are under review, including individual income tax rates for higher earners, capital gains taxes, corporate tax rates, and estate taxes.

Other policy areas likely to change under new Democratic leadership are foreign relations, immigration, healthcare, and infrastructure. President Biden quickly introduced two stimulus bills, starting with a $1.9 trillion stimulus plan. This was followed by a $2 trillion infrastructure proposal.

The second key event in Q1 was the rollout and increasingly broad availability of the COVID vaccine. A combination of the vaccine, continued mask wearing and social distancing, and stimulus will likely push the U.S. to the end of this pandemic.

These two events may be cause for concern for investors as oncoming higher interest rates and higher taxes may signal a temporary peak in equity prices. Nevertheless, an optimist may characterize a flat-lining of equity returns as a long overdue pause for an asset class that averaged 16% returns for the past five years.

Investment Outlook

Conifer Bay Capital’s investment outlook remains cautious. We remain at or below target weights in equities because of their high valuations. Similarly, bond holdings are biased toward shorter maturity bonds, which may suffer less in a rising interest rate environment.

As we highlighted at year-end, we do not expect a sharp drop in equity prices but rather a year of ups and downs. 2020 laggards (energy, financials, and REITs) are already doing better, outpacing 2020 leaders (technology, healthcare, and work-from-home stocks).

We recently made a portfolio change to reduce or eliminate gold investments. While we continue to like gold as a high-quality bond alternative in this low interest rate environment, enough factors have been weighing on gold prices recently that we temporarily reduced portfolio exposure. While we have no target for increasing gold holdings in the immediate future, precious metals remain on our radar.

Meanwhile, we think the emerging market equity sector remains an attractive investment opportunity relative to U.S. and foreign developed markets. The Asian emerging markets, particularly China, remain a key driver of global economic growth. The sector has near-term risks, including important political, human rights, and trade issues that some investors may find troubling. However, the long-term fundamental picture of China remains very encouraging.

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Graphics source: JP Morgan Asset Management, 3/31/2021, unless noted otherwise.