Coming off an unprecedented year in financial markets, domestic equities continued to move higher in the first quarter of 2021, with the S&P 500 Index rising 6.2% to finish at an all-time high. An improving labor market, a healthy rise in consumer spending, and a growing deployment of vaccines provided investors with greater clarity into the country’s ongoing economic revival and guided domestic equities’ quarterly performance. However, while the prior year’s performance was mainly defined by a relative outperformance in technology and growth-related names, the energy, financial, and industrial sectors were the primary contributors during the quarter. The rotation into these sectors was reflective of a larger pattern of value-oriented sectors outperforming their growth-based counterparts, bucking the long-standing trend of growth’s dominance. Additionally, the improving economic backdrop continued to support small-cap stocks, which are more sensitive to economic conditions but tend to fare better during recoveries. As such, small-caps led the way during the quarter, followed by mid-caps and then large-caps.
On the international front, both developed and emerging market equities recorded positive returns on the quarter but came in weaker than domestic equities. The MSCI EAFE Index, which tracks developed market equities, registered a quarterly gain of 3.6% despite new lockdown measures and vaccine deployment challenges afflicting many European countries. While a recovery is unfolding throughout these developed market nations, it has shown to be lukewarm, with corporate earnings estimates continuing to be revised down. On the flip side, emerging market nations have seen a strong and robust economic recovery, despite returning only 2.2% on the quarter, as defined by the MSCI Emerging Market Index. China continued to be at the forefront of the emerging market space, with economic activity returning to pre-pandemic levels and economic forecasts coming in stronger than expected.
In the fixed income market, the predominant focus shifted from the Federal Reserve’s ultra-accommodative policies to a sharp rise in long-term yields. The U.S. 10-year Treasury Note ended the quarter yielding 1.74%, up from the prior quarter’s 0.91% yield, and marked the largest quarterly rise in more than four years. This sizable move in yields came as investors began to price in rising inflation expectations associated with the re-normalizing of the U.S. economy and prior fiscal stimulus aid. As inflation expectations increase, investors demand higher yields for holding Treasuries. Against this backdrop, fixed income returns were relatively flat to negative during the quarter with longer duration bonds among the worst-performing. Municipal bonds outperformed their corporate counterparts for the most part and higher-yielding bonds generally led the pack in both the corporate and municipal bond spaces.
Outlook – One year into the COVID-19 pandemic, society has slowly begun to turn the page, with investors grasping how the new “normal” may look. While the path of the virus and vaccine will likely remain a key driver of market behavior over the coming quarters, most economic barometers point to a U.S. economy that is in the midst of a healthy and durable recovery. The labor market continues to improve meaningfully. The headline unemployment rate fell to 6.2% during the quarter – a material decline from the roughly 15% rate seen at the outset of the pandemic. U.S. gross domestic product (GDP) continues to be revised upward. U.S. GDP is expected to rise 5.6% in 2021 on the back of a roughly 12% jump forecasted for the second quarter of this year. Household balance sheets remain strong with the unprecedented fiscal and monetary levers further aiding household net worth. In aggregate, these improving economic fundamentals have helped support the market’s continual grind higher over the prior quarters.
Looking ahead, we at Condor remain cautiously optimistic on the state of financial markets. We continue to see a post-pandemic economic recovery unfolding supported by a robust economic expansion and elevated consumer spending. As we move into the back half of the second quarter, we expect vaccinations to be readily available to much of the U.S. population. At first quarter’s end, around 20% of the U.S. population had been vaccinated, with end of second quarter estimates sitting around 60%. If this holds true, and reduced economic restrictions follow, consumer spending – which accounts for roughly 70% of U.S. economic activity – could be supportive of a move higher in markets. That said, the impact that pent-up consumer spending will have on inflation is going to be one of the main focal points for the market over the near-term. While some investors are expecting a sharp rise in inflation, we expect a modest, though temporary, rise guided by higher-end goods and services. Given that we expect a majority of inflation to come from the higher end rather than housing and food, we don’t see enough inflationary pressure for the Federal Reserve to raise interest rates. In fact, we believe that rates will arrive at an average over the medium- to long-term.
As we begin to turn the page on this unforeseeable pandemic, we want to remind our clients about the importance of staying invested – through a targeted and diversified approach – during times of market volatility. The market movements at the onset of the pandemic were an unfortunate reminder that equities can be volatile in the short term. However, making knee-jerk decisions to sell out of the market or time the market can often backfire when equities start to move higher. Thus, while the market’s initial drawdown may have been uncomfortable, by staying invested and focusing on your long-term objectives, your portfolio would have been aided by the broader market’s recovery. As a result, we continue to advise against basing asset allocation decisions on short-term moves and trends, but rather advocate for staying the course with a comprehensive, diversified portfolio based on your long-term goals and needs.