At a glance
We remain optimistic about diversified investment portfolios’ forward prospects but acknowledge an uneven forward path.
We continue to monitor two horizons for our clients, the first representing trends toward economic reopening and the second contemplating the economic environment once we have achieved herd immunity. We remain optimistic about diversified investment portfolios’ forward prospects but acknowledge an uneven forward path. Medical progress has been encouraging, yet vaccination uptake remains uneven across geographies. The confluence of vaccinations, pro-growth public and monetary policies, increased mobility by consumers and increased spending could generate inflationary pressures for central banks to ponder in coming quarters.
Investors have enjoyed a three decade-plus bull market in bond prices, driving yields (which move inversely with prices) to historic lows in March 2020. As markets anticipate a transition from horizon one to horizon two, we continue to monitor developments across capital markets, with the bond market a particular focal point. An abrupt rise in interest rates since the start of the year has investors thinking about implications across markets, and this outlook offers our perspective on what we are focused on for our clients and their portfolios. While a range of outcomes exist, we retain a glass half-full viewpoint and expect patient investors to be rewarded for the risks they bear.
― Eric Freedman, Chief Investment Officer, U.S. Bank Wealth Management
Global economy
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- The global economy remains in recovery mode as we enter 2021. However, there remains significant differentiation in the pace of recovery driven by an uneven reopening from the coronavirus pandemic. Our expectation of softer growth to finish the year is subject to a wide range of outcomes based on the timing and magnitude of economic reopening.
- Strong U.S. first half growth likely moderates to finish the year. However, pent-up consumer demand could lead to further growth gains. The high savings rates of recent stimulus payments coupled with potential employment gains from reopening could drive an upside surprise to growth.
- An uneven recovery in Europe indicates growth prospects favor Asia. Activity is likely to moderate in Asia in the near term, reflecting the impact of earlier pandemic closures. However, growth levels still favor Asia, despite potential credit growth limitations in China. Europe continues to struggle with coronavirus infections and slow vaccine distribution. While a late summer reopening appears likely to lift growth, absolute levels of activity likely remain modest due to an aging population and more limited stimulus measures.
U.S. equity markets
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- Volatility is likely to persist as inflation looms on the horizon. Periods of elevated volatility were key features of U.S. equity market performance in the first quarter, a trend we envision continuing for the foreseeable future. While not our base case, increased volatility would likely accompany stronger-than-anticipated inflation, because rekindling inflation and higher interest rates typically result in more subdued equity returns.
- The relationship between inflation and valuation is clear. On balance, an inverse relationship exists between inflation and prices investors are willing to pay for equities relative to earnings, or the price/earnings multiple. Price/earnings multiples tend to decrease as inflation moves meaningfully higher.
- Rising earnings estimates provide valuation support. Earnings are trending higher, with consensus analysts’ estimates for the S&P 500 in 2021 approaching $175 per share as the second quarter begins. Companies have cited progression toward COVID-19 herd immunity and related economic reopening worldwide, as well as spending associated with additional government stimulus, as items driving revenue and earnings growth.
- Both secular-growing and cyclically-oriented sectors have attractive investment characteristics as we contemplate two time horizons ― the current economic recovery and the steady state after full economic reopening. Ongoing monetary and fiscal stimulus in concert with vaccination progress suggest cyclically-oriented sectors, which tend to move with overall economy, remain favorably positioned in the current recovery horizon. Similarly, the longer-term, post-recovery horizon outlook for secular (longer-term) growing sectors remains compelling, spurred by positive trends in digitization, artificial intelligence, machine learning, mobility and e-commerce.
- U.S. equities’ dividend profile remains compelling despite rising interest rates. Equities remain an attractive alternative for investors looking for income, mindful of their risk profile. Approximately 41 percent of S&P 500 companies offer dividend yields (the expected dividend per share divided by the current price per share) above the U.S. 10-year Treasury note yield as the second quarter begins.
Foreign markets
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- Foreign developed equities retain catch-up potential in a global economic recovery. Slower vaccination progress relative to the United States continues to challenge Europe’s near-term recovery path. However, muted performance compared to U.S. equities suggests investors have not yet fully priced in the region’s recovery potential while a post-reopening scenario, though delayed, remains intact.
- Foreign equities’ valuation, or the price investors are willing to pay for anticipated earnings, remains elevated relative to history. While continued vaccine progress provides optimism for a 2021 profits recovery, high valuation leaves little room for error in the event companies don’t deliver anticipated revenue or earnings growth.
- Local government policies highlight risk considerations for emerging market investors. Emerging markets continue to provide attractive investment opportunities for investors. However, last year’s intervention by Chinese authorities in a highly anticipated initial public offering and this year’s intervention by Brazilian officials in that country’s largest oil producer highlight additional policy risks investors must navigate.
- China consumers remain key to foreign emerging equities’ fortunes in 2021. China’s largest publicly traded companies are no longer state-owned enterprises in the Energy and Financials sectors; they’re consumer-oriented e-commerce, mobile gaming and social media enterprises. China was among the countries earliest hit by the COVID-19 pandemic and earliest to reopen and Chinese consumers’ ongoing return to normalcy remains key to the region’s fortunes.
Bond markets
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- Treasury bond yields rose quickly in the first quarter but remain low by historical comparisons. We anticipate the Fed keeps its policy rate near zero for an extended time. The Fed retains an option to expand Treasury purchases if rapidly rising bond yields threaten the recovery. Rising growth and inflation expectations may push longer-term bond yields higher, but rates are unlikely to return near historical averages in the near term. Treasury bonds provide important portfolio diversification, but low and rising yields indicate better opportunities exist elsewhere to enhance yield and performance.
- Riskier high-yielding bonds are still interesting relative to traditionally higher quality options. Investment-grade bond yields remain near all-time lows and are rising, pressuring prices and performance. However, riskier bonds offer meaningful incremental income and a degree of cushion against rising Treasury yields. Bond issuers have larger cash balances and have experienced very low instances of default and distress in recent months, bolstering their credit quality. We favor higher income opportunities such as high yield bonds, bank loans and mortgage bonds not backed by the government.
- Municipal bonds provide a valuable source of non-taxable income. Rapidly improving sales and income tax revenue paired with significant fiscal stimulus directed at state and local governments supports municipal bond credit quality. We see opportunities in high yield municipal bonds, but encourage limited exposure and emphasize credit selection considering the degree of idiosyncratic risks.
- Opportunities remain in non-government-backed residential mortgages. Yields are high relative to other bond sectors, while fundamentals remain strong. Many homeowners in forbearance never stopped making mortgage payments, while those coming out of forbearance are performing better than originally anticipated. Current loans falling 30 days or more past due have reached pre-COVID levels, indicating low interest rates, high borrower equity and a robust housing market are encouraging borrowers to remain current on their loans.
Real assets
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- An economic expansion, declining dollar and increasing inflation expectations are favorable for commodities; prices for agricultural products, industrial metals and energy should trend higher. Commodity producers appear to be the primary beneficiaries among real assets at the expense of precious metals.
- Excess capacity exists in retail properties, as well as office and multi-family properties in the urban core. Ample supply likely limits rent growth in these property types, leading to disappointing future revenue and earnings. Real estate investment trust dividend growth is likely limited in the near term.
- Crude oil prices accelerated in the first quarter, with major producers cutting production. With demand increasing, crude supplies continued to decline. For now, it appears the major producers will keep forward supply balanced with potential demand. This should allow crude oil prices to rise further as inflation accelerates. Energy sector equities should benefit from a continued economic expansion.
Hedge fund strategies
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- Social media became a capital market influencer in 2021, though we believe its effects will prove limited and transitory. The volatility in social media influenced stocks such as GameStop, resulting in painful lessons for a few hedge funds positioned for price declines. Significant losses were attributable to a coordinated effort by retail investors to push the prices higher.
- Changing market dynamics are ahead under a new administration with a policy agenda likely to benefit some sectors and companies over others, as will the impact of rising Treasury yields. Many growth-oriented Technology and Healthcare firms do not pay dividends, making their valuation dependent on the values of future cash flows and the interest rate that discounts those cash flows.
- Technology and Healthcare companies remain key economic drivers based on innovations to benefit our everyday lives. These impacts will likely prove more durable and longer-lasting than social media-influenced price swings.
Private markets
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- Continued strength in IPO markets favors private market investors, allowing for more private companies to seek liquidity from the public markets while generating strong returns for investors.
- Demographic shifts, changing consumer behavior, innovation cycles and dislocations due to shutdowns provide private market investment opportunities. These opportunities span from industrial real estate used for e-commerce, to digitization across industries and development of innovative new therapeutics that enable one’s own immune system to fight cancer.
- Historically high private market valuations emphasize the need for investment managers to drive growth within their portfolio companies. Cost rationalization achieved during the challenging economic environment of 2020 combined with the secular growth trends creates opportunities for experienced private market investment managers to deliver attractive returns.
This commentary was prepared March 2021 and represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are not intended to be a forecast of future events or guarantee of future results and is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank or U.S. Bancorp Investments in any way.
U.S. Bank, and representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation. Diversification and asset allocation do not guarantee returns or protect against losses. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.
Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with investments in real assets such as commodities and real estate securities. For commodities, risks may include market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). Hedge funds are speculative and involve a high degree of risk. An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem or transfer interests in a fund. Private capital investment funds are speculative and involve a higher degree of risk. These investments usually involve a substantially more complicated set of investment strategies than traditional investments in stocks or bonds, including the risks of using derivatives, leverage, and short sales, which can magnify potential losses or gains. Always refer to a Fund’s most current offering documents for a more thorough discussion of risks and other specific characteristics associated with investing in private capital and impact investment funds. Private equity investments provide investors and funds the potential to invest directly into private companies or participate in buyouts of public companies that result in a delisting of the public equity. Investors considering an investment in private equity must be fully aware that these investments are illiquid by nature, typically represent a long-term binding commitment and are not readily marketable. The valuation procedures for these holdings are often subjective in nature. Private debt investments may be either direct or indirect and are subject to significant risks, including the possibility of default, limited liquidity and the infrequent availability of independent credit ratings for private companies. There are distinct risks associated with Special Purpose Acquisition Companies (SPACS) and they may not be appropriate for all investors. It is important for investors to understand the specific features of any SPAC under consideration and carefully consider the associated risks in light of individual goals, risk tolerance, investment horizon and net worth.
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