April lived up to its reputation as a positive month for equities. Many global indices hit all-time highs during the month, supported by a combination of record fiscal/monetary stimulus and optimism around the global economic recovery. Even with a third wave of the virus raging in pockets of the world, markets are cheering the successful vaccination rollout in the U.S. and hope that by summer many parts of Europe and Canada will be on the same path.
Where the optimism is most notable is in the commodities. The pent-up demand to spend on goods and services is massive, and global supply chains have been struggling to keep up. Lumber is a common example of this trend, but it’s everywhere. Oil, which in April 2020 traded below zero, is comfortably over $60 a barrel. Corn and other agricultural commodities are up over 40% YTD, and copper ended the month at levels last seen in 2011.
These commodity moves have brought warnings about inflation from many corners. A little inflation is good, as it keeps growth, but runaway inflation can destroy business models and countries. Central banks usually list the objective of low inflation as one of their primary responsibilities. As the year progresses, this will become even more of a talking point.
At the moment, bankers are pushing back against inflation fears, saying its “transitory,” meaning the surge in prices won’t last. They attribute the surge to growing pains from restarting global supply chains that had been shut down for most of last year. That excuse may be true if the deflationary factors of demographics come back into focus, but if commodities continue to run into the second half of the year, it may become too big of an issue to ignore.
The bond market is making its bet in this debate, as bond yields look to be signaling that this price move may be more long lasting. Less than a year ago, the U.S. 10-year bond was yielded under 0.5%. It ended April over 1.6%, and many are expecting it to finish 2021 over 2%. If inflation expectations keep increasing, yields will follow. This will have an impact on what sectors will win and what markets will outperform. You can’t ignore the bond market.
The biggest story in markets remains the record levels of stimulus and cash in the system. It is flowing to all asset classes, but as investors begin to lose money in bonds, increasingly this cash is coming to equities and real assets. This makes it hard to short this market, other than for tactical reasons—that is until the central banks decide they have had enough. Remember, “Bull markets don’t die of old age—they are murdered by the Fed.”
An old investment adage states to “sell in May and go away.” But is that true in 2021? It’s trickier this year than in many others. Last year was certainly not a year to sell, but that was because markets had been crushed in the first part of the year and were rebounding from that shock. This year the S&P 500 is higher by 11.3% for the first four months. Markets usually don’t peak until earnings do, and for the next few quarters pent-up demand should push prices higher. But by the second half of the year could things have gone too far?
The market observers are rightly focused on determining when the FOMC will take away the punch bowl, signaling that the party is over. But markets are forward looking and once that time arrives it will be too late. Positioning for that new environment will have to be done earlier. This doesn’t mean markets will crash, but a dramatic change in leadership could occur. When the economy is struggling, investors pay a higher multiple for those few companies that are winning.
But as we begin to envision a world of 3% unemployment, 3% GDP growth, and a 3% 10-year yield, investors no longer need to pay huge multiples for growth as it’s more common. Does this mean they may begin to favour cyclical companies with a strong balance sheet and cash flow? Value stocks may finally come back to favour after many years of being ignored.
Markets are off to a great start to the year, climbing a wall of worry. The second half of the year will face several new challenges as stimulus programs begin to be scaled back and the focus turns to tax hikes as governments look to pay for this. Selling in May might be too soon, but it’s coming. Investors will need to be nimble to get ahead of these factor changes before everyone sees it has arrived. After many years when holding index funds was all that mattered, active management is making a comeback. Strategies that add value through positioning within assets classes, sectors, and duration should outperform.
The world is still recovering from the shock of the pandemic and finally there is light at the end of the tunnel—but just because the all-clear has been sounded doesn’t mean investors can let their guard down.
— Greg Taylor, CFA is the Chief Investment Officer of Purpose Investments
All data sourced from Bloomberg unless otherwise noted.
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