- Led by the U.S., global equity markets continued their advance throughout most of March as the MSCI All-Country World Index returned 2.7% for the month.
- March’s equity market performance was a tale of two halves where the 2nd half of the month saw a sharp reversal.
- The intramonth reversal was most prominent with U.S. small versus large cap. Around mid-month, U.S. small caps (S&P 600) were up almost 10% before nosediving but ending up 3.3%.
- After lagging throughout much of the 1st quarter, defensive sectors such as Utilities, Consumer Staples, and Real Estate were among the top-performing sectors alongside traditional cyclicals.
- The markets expect the good times to roll with vaccination rollouts and strong economic growth while they are less concerned about inflationary pressures and potential market disruptions.
Tempests in Teapots
"Be collected. No more amazement. Tell your piteous heart there’s no harm done."
– Prospero to Miranda following a shipwreck, Shakespeare’s Tempest
Global equities continued their strong advance this quarter, led by U.S. stocks, despite a number of ‘tempests’ that had threatened to disrupt the pandemic-recovery narrative. It turns out that most of these tempests merely had teapot impacts on volatility and investor sentiment but not nearly enough to throw pro-cyclical risk assets off their upward trajectory. Just like Prospero’s assurances to Miranda, no harm was apparently done as the S&P 500 Index continues to reach new all-time highs and high yield corporate credit spreads compress to multi-decade lows. Yes, there was quite a bit of heartache throughout the quarter, especially for individual actors involved in the tempest dramas, but as with Shakespeare’s play, the first quarter had a happy ending with risk-based assets trading near all-time highs.
Here is a quick summary of some of this quarter’s market-moving tempests that threatened to destabilize the markets but that have been ‘contained’ so far:
- The Reddit-driven Wall Streets Bet short squeeze targeting short positions held by large institutional hedge funds (see our January 2021 Market Commentary).
- Rising volatility in interest rates following an anemic reception to the 5- and 7-year U.S. Treasury Note auction in late February (see our February 2021 Market Commentary). Subsequent Treasury auctions ran more smoothly, yet long-term interest rates reached post-pandemic highs as the fixed income markets try to digest massive fiscal stimulus spending and higher inflation expectations.
- Emerging markets headline risk on the rise led by Turkey which saw the lira tumble following the removal of the country’s third central bank governor in two years. Many central banks are facing a squeeze of tighter interest rate policies in the face of rising inflation expectations despite lagging the developed world on vaccinations.
- Supply-chain disruptions from reports of semiconductor chip supply shortages (reverberating through automobile production) to the Ever Given container ship blockage of the Suez Canal.
- European countries lagging the U.S. and Asia in COVID-19 vaccination rates resulting in renewed lockdowns that could threaten the summer holiday season.
- The collapse of Greensill Capital, a major financier of trade payables, which led to major losses for Credit Suisse Asset Management which had invested in Greensill short-term debt collateralized by supplier invoices.
- Massive liquidation of approximately $30 billion of equity-linked positions held by family office Archegos Capital Management through total return swap contracts facilitated by major prime brokers like Credit Suisse, Nomura, Goldman Sachs, Morgan Stanley, and Wells Fargo. Apparently, the Archegos faced a major margin call following initial drawdowns of underlying securities held on margin at these banks.
For now, these are tempests in teapots although it remains unclear what the long-term ramifications are for global risk asset pricing and whether capital market activities continue to remain on sound footing considering the Archegos Capital revelations. The Archegos’ liquidation hit the markets hard over a two-day period and revealed how yesterday’s ‘swing-for-fences’ risk-taking hedge funds have morphed into wealth management family offices like Archegos. Could the markets withstand further large block selling pressures as bank compliance officers and government regulators take a ‘harder’ look at the underlying derivatives that helped fund the outsized leverage taken by Archegos?
It turns out the over-the-counter total return swap (TRS) derivatives facilitated by the prime brokers enabled Archegos to take on significant leverage in individual stocks without having to disclose the firm’s holdings to regulators. Granted these stock positions were hedged with offsetting equity market shorts, but the TRS derivatives were marked-to-market daily and susceptible to margin call liquidation risks similar to what happened to Long-Term Capital Management in 1998. However, unlike LTCM in 1998 where all the major bulge bracket money centers, more or less, ‘knew’ about the giant elephant making massive leverage bets (as expertly documented in Roger Lowenstein’s When Genius Failed), apparently, the prime brokers involved with Archegos were unaware of each other’s leveraged positions until the large block liquidations began suddenly.
The Archegos position liquidation led to major selloffs in the share prices of Credit Suisse Group (CS) and Nomura (NMR) as well as a spike in their implied debt financing costs as priced in by credit default swaps. For Credit Suisse, the combined losses from Greensill and Archegos could lead to a precarious state for the bank’s Tier 1 capital ratio to risk-based assets as attempts to raise this ratio could lead to even more liquidation of risk-based positions.
That all said, risk asset performance (equities, corporate credit, commodities) has been jarred but not outright disrupted by these tempests, relegating them to teapots with little concern for broader contagion that would spread across the markets. Apart from a steady rise in the U.S. dollar (Figure 1) that could portend tightening global financial conditions, pro-cyclical risk assets such as corporate credit spreads (Figure 2) and industrial commodities (Figure 3) imply that the economic drivers from the post-pandemic recovery will likely outweigh micro-level disruptions.
Figures 1 – Risk-Off Coal Mine Canary: U.S. Dollar Strength Foretelling Tighter Financial Conditions?
Figure 2 – Not Worried About the Tempests: Risky Corporate Credit Spreads Narrow to Multi-Decade Lows
Figure 3 – Industrial Commodities Take a Breather Following a Torrid Run Throughout the Quarter
Despite the Federal Reserve’s assurances and dot-plot forecasts for targeting their benchmark overnight rate to the zero bound through at least 2023, both U.S. dollar appreciation and Fed Funds/Eurodollar futures are implying earlier tightening around 2022. Coming out of the pandemic-induced shutdowns of 2020, the world finds itself catapulted (and perhaps squeezed) by a strong recovery from the twin economic pillars of the U.S. and China as Bloomberg consensus expects CY2021 real GDP growth of 5.7% and 8.5%, respectively.
After being relegated as the ‘funding’ currency for global-driven reflationary growth, currency trader sentiment on the U.S. dollar has abruptly shifted to one of strength from weakness (Figure 4). The U.S. dollar is, once again, flexing its muscle as the currency of choice (just as it did in 2018-2019), as global investors are gravitating towards the U.S. markets which are enjoying a differential in 1) interest rates, 2) growth expectations, 3) vaccination progress, and 4) less ‘drama’ versus Europe and Emerging Markets.
Figure 4 – Currency Trader Sentiment Shifts from Weak to Strong U.S. Dollar
Sentiment may continue to trend favorably towards the U.S. following the massive fiscal stimulus being proposed by the Biden Administration even if such spending will be funded by higher taxes on corporation and high earners. For now, the U.S. dollar sits in the catbird seat as the better story in the post-pandemic recovery.
U.S. equities have also reasserted their leadership after having lagged throughout the first of this quarter. Figure 5 displays the expected earnings trajectory for the major equity market regions with the S&P 500 (top chart) and Russell 2000 (bottom chart) expected to lead the recovery along with emerging markets. Although emerging markets' earnings are expected to pace the developed markets, U.S. outperformance is implying a clearer path for achieving that recovery in earnings.
Figure 5 – Corporate Earnings Base Effect: Trajectory Off CY2000 Pandemic Lows
Source: Bloomberg through 3/31/2021. Time series indicate % increase or decrease of current forward EPS expectations versus expectations from the prior year.
Fed Says No Taper (Tantrum) Until 2023
As written earlier, there is a tug-of-war between Federal Reserve officials and the bond market over when the Fed is expected to ‘taper’ or tighten monetary policy, such as the removal of emergency measures like quantitative easing. The bond market continues to be on the lookout for a repeat of the 2013 taper tantrum that sent real (inflation-adjusted) interest rates soaring (Figure 6). Despite the 10-Year U.S. Treasury Yield rising from 0.91% at the beginning of the year to a post-pandemic high of 1.74% at quarter-end, real rates have only moderately risen from the pandemic lows. This suggests that Fed policy remains highly accommodative which is conducive for loose financial conditions (Figure 7).
Figure 6 – Compared to the 2013 Taper Tantrum, Real Interest Rates Have Not Risen That Much Off the Pandemic Lows
Source: Bloomberg through 3/31/2021.
Figure 7 – U.S. Financial Conditions Remain Very Loose Despite the Rise in Rates
As we wrote in the February 2021 Market Commentary, both the Fed and the Biden Administration have argued that more fiscal/monetary stimulus is needed to close the unemployment gap for those displaced by the pandemic. One area of displacement has been the older worker demographic (55 years and older) which has experienced a major drop in labor force participation (much of it involuntarily) (Figure 8).
Figure 8 – Employment Gap – Sharp Drop in Older Workforce Labor Participation
Comments from Fed officials also point towards the employment gap between top earners who have recovered most of the pandemic losses versus the bottom tier which continues to struggle (Figure 9). The trajectory of future monetary policy shifts will likely be influenced by the progress of the bottom-tier wage cohort as well as the stability of overall capital market conditions (not desiring a repeat of the March 2020 market meltdown).
Figure 9 – Employment Gap Widens Between Top versus Bottom Wage Earners
Yet the Fed and the bond market cannot ignore the possibility that the price pressures building up at the raw and intermediate producer level (Figure 10) could translate into higher consumer prices which could be problematic to the Fed’s dual mandate of achieving price stability and full employment. Perhaps, businesses will end up absorbing higher prices through lower profit margins, but at least some of this pricing pressure will likely find its way into final prices.
Figure 10 – Federal Reserve Regional Surveys Point Toward Increased Pricing Pressures
For now, the ‘inflation is transient’ stance adopted by the Fed remains the consensus outlook as pricing pressures mainly stem from bottleneck shortages, as can be seen with a decline in supplier delivery times (Figure 11) and disruptions (Figure 12). The thinking is that supply chain bottlenecks, whether semiconductor chip shortages, global shipping constraints (exasperated by Suez Canal blockage), and supplier delivery times, are short term in nature and are expected to correct or normalize once we move to a more normalized economic environment following the expected surge in pent-up demand.
Figure 11 – Supplier Delivery Times Under Increased Strain
Figure 13 – A Majority of Surveyed Manufacturers Have Experienced Supply Chain Disruptions
So, to sum up: the markets expect the good times to roll with vaccination rollouts and strong economic growth while less concerned about inflationary pressures and potential market disruptions induced by easy financial conditions, whether YOLO Robinhood retail traders or leveraged family offices. Despite this year’s market advance, stock market valuations have dropped from their 10-year (albeit extreme) highs (Figure 14). The earnings multiple compression is coming from rising earnings expectations, so as long as the earnings story remains intact, then another major blow-off seems remote, tempests notwithstanding.
Figure 14 – Forward Price/Earnings Multiples Are Off the 10-Year Highs as Earnings Continue to Recover
As has been the pattern for the last several months, March’s equity market performance was a tale of two halves where the 2nd half of the month saw a sharp reversal from the 1st half even though equity markets ended positive for the month. COVID continues to drive day-to-day volatility where investor sentiment seems to be driven by vaccination progress (or lack thereof).
Led by the U.S., global equity markets continued their advance throughout most of March as the MSCI All-Country World Index (NASDAQ:ACWI) returned 2.7% for the month. Across major regions (Figure 15), the S&P 500 returned 4.4% followed by MSCI Europe (+3.3%). Pan-Asian markets underperformed in March with MSCI Japan returning 1.1% while Emerging Markets and Asia ex-Japan and were down for the month, returning -1.5% and -2.1%, respectively. Both emerging markets equity and debt were hurt by U.S. dollar appreciation.
Figure 15 – U.S. and Europe Lead Major Regions While Emerging Markets and Asia Lag
The intramonth reversal was most prominent with U.S. small versus large-cap performance (Figure 16a). Around mid-month, U.S. small caps (S&P 600) were up almost 10% before nosediving to negative territory but ending the month positive 3.3%. In contrast, U.S. large caps (S&P 500) followed a steady upward move throughout the month, returning 4.4%. S&P Pure Value (+6.8%) handily outperformed Pure Growth (-0.2%) although this gap narrowed during the 2nd half of the month (Figure 16b).
Figure 16 – U.S. Small Reversed Sharply in the 2nd Half of March; Value Outperformed Growth
After lagging throughout much of the 1st quarter, defensive sectors such as Utilities, Consumer Staples, and Real Estate were among the top-performing sectors alongside traditional cyclicals such as Industrials and Materials (despite negative commodity returns) while traditional growth sectors (Technology, Healthcare, Consumer, Communication Services) lagged along with Energy. However, all sectors generated positive returns in March (Figure 17).
Figure 17 – Defensive Sectors and Traditional Cyclical Sectors Outperformed Growth Oriented Sectors and Energy
The strong performance of Utilities helped propel the High Dividend Factor as the top-performing factor in March alongside Value and High Quality while Momentum underperformed (Figure 18) after having led throughout most of the month. Value and High Quality outperformed High Dividend and Min Vol, both likely hurt by higher interest rates.
Figure 18 – High Dividend, Value, and High Quality Outperform While Momentum Lagged
As interest rates rose to a post-pandemic high, investment grade fixed income posted another monthly loss despite corporate and mortgage-backed spreads holding steady. The Bloomberg/Barclays US Aggregate Bond Index dropped 1.2% mainly due to a rise in interest rates as the 2-10 year term structure steepened and inflation expectations priced into TIPS vs nominal Treasury yields rose to post-pandemic high. However, U.S. high yield continued to enjoy moderate gains as high yield spreads remain below 3% and are near multi-decade lows. The Bloomberg/Barclays US High Yield Index returned 0.1% as tighter credit spreads helped offset the effects of higher interest rates. Foreign currency and emerging market debt underperformed due to a combination of higher interest rates and a stronger U.S. dollar.
Figure 18 – Higher Inflation Expectations Priced into the Bond Market Via a Steepening Yield Curve and Rising Breakeven Rates Between TIPS vs Nominal Treasuries
Figure 19 – US High Yield Outperforms Other Fixed Income Sectors
Within equity alternatives (Figure 20), Commodities took a breather following strong performance through February, dropping 2.2%, while Precious Metals (primarily gold) dropped 1.7% as the safe-haven demand for gold diminishes in the face of pandemic recovery. The Dow Jones REIT Index outperformed the broader U.S. market, returning 5.5% as higher yield equities performed well in March.
Figure 20 – Commodities Took a Breather in March While REITS Performed Well
1st Quarter 2020 Charts and Exhibits
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