The 1st quarter of 2021 saw volatility in the investment markets caused by two things we haven’t seen in quite a while – higher interest rates and the fear of higher inflation. Using the yield of the 10-year Treasury bond as the measure, this yield increased from 0.9269% on December 30, 2020 to 1.74% on March 31, 2021 – more than an 87% increase. While the Dow Jones Industrial Average and the S&P 500 performed well during the quarter, there was something quite dramatic happening below the surface.
This year there has been growing optimism about the prospects for a more rapid COVID-19 vaccine development and distribution. As an increasing number of people were getting vaccinated and the number of deaths resulting from COVID steadily declined, the outlook for the post-COVID economy improved rapidly. In fact, the International Monetary Fund (IMF) recently reported that they estimated the U.S. “real” gross domestic product (GDP adjusted for inflation) for 2021 to be 6.4%.
Over the last three years, growth stocks – technology in particular – have out-performed value stocks (to include financials, energy and industrials) by a wide margin. In 2020 alone, the Russell 1000 Growth outperformed the Russell 1000 Value by 35.69% (38.49% vs. 2.8%) – which drive much of investor’s superior performance relative to the S&P 500 in 2020. This performance differential has caused a dramatic shift (or over-weight) toward growth stocks over the last three years at the expense of owning value stocks in many managed portfolios. But by the end of 2020, growth stock valuations began to show signs of being extended, and perhaps over-extended. With the outlook for the post-COVID U.S. economy improving, there has been a not-so-subtle rotation to more attractive valuations being offered in cyclical, or value, stocks. Cyclical stocks are companies whose underlying businesses tend to follow the economic cycle of expansion and recession.
Growth/value stock performance cycles have tended to last for several years (as growth stocks have most recently), but style changes can be abrupt when they occur, particularly in extreme circumstances. By several key measures it appears that an economic recovery from COVID and rising interest rates (and potentially rising inflation) have created such extreme circumstances that now warrants adding cyclical stocks not previously held. This by no means is suggesting an over-weight to value away from growth, rather to maintain a balance of growth (focused on technology) and value (cyclical) stocks in the equity portion of a portfolio.
Bonds in general have taken it on the chin so far in 2021 with the Bloomberg Barclays Capital U.S. Aggregate Bond Index losing 3.37% in the 1st quarter, and as such were a drag on portfolio performance. A bond’s duration, measuring its sensitivity to interest rates, and its quality had a great deal to do with how it fared over that period. For example, the Bloomberg Barclays Capital U.S. 1-3 Year Treasury Index was roughly flat for the 1st quarter, surviving the rising interest rate environment much better than longer duration bonds. Also, low quality bonds, also known as junk bonds, also fared better than higher-quality corporate or government bonds. Our strategy in this environment is to keep the overall duration of the bond portions of our portfolios short while maintaining a diversified balance of bond type and quality.