Outlook: Second quarter 2021

Economy

The economy continues to rebound at a relatively fast pace fueled by two recent government aid packages that total $2.8 trillion, aggressive monetary stimulus and the gradual return to more normal lifestyles. In the fourth quarter of 2020, the economy expanded at a 4 percent annualized rate and this year it is expected to grow by almost 6 percent. In fact, it is possible that the economy may grow beyond its pre-COVID peak by this summer.

In late December of last year, the U.S. government passed a $900 billion aid program that extended enhanced unemployment benefits and the ban on evictions. It also provided $600 checks to individuals in need. Given concerns that this would not be sufficient, the government passed another aid package in March that totaled $1.9 trillion. This program extended the enhanced unemployment benefits, provided $1,400 checks to individuals and allotted aid to states and schools. With the addition of these two packages, the government has provided more than $5 trillion in aid over the last year. At that level, the aid packages total almost one quarter of the size of our economy at its pre-COVID peak.

Inflation

Inflation stabilized in the latter half of 2020 after falling close to zero earlier in the year. Recently, inflation has been rising and we expect that trend to continue as the economy recovers. Given the sharp decline in price levels last year we may see some large annual increases in statistics like the Consumer Price Index, but it remains to be seen whether these increases will be transitory.

U.S. dollar

Given the dramatic rise in intermediate and long-term interest rates in the U.S., as well as expectations for relatively strong economic growth in America, the U.S. dollar has increased in recent months. Looking forward, we expect the U.S. dollar to remain elevated in the near term. However, on a longer-term basis our high level of government debt and improving conditions in foreign economies may weaken our currency.

Asset class

CASH/MONEY MARKET INSTRUMENTS

Increasing concerns regarding inflation have raised interest rates on the longer end of the curve yet yields on money market instruments remain stable and continue to reflect the Federal Reserve’s ability to control short term interest rates. Money market rates are likely to remain close to current levels for the foreseeable future as the Federal Reserve has reiterated its stance on allowing inflation to run higher than its historic 2 percent target.

INTERMEDIATE GOVERNMENT/CREDIT BONDS

Year to date the yield on the 10-year Treasury bond has increased close to 0.80 percent. The rise in yields reflects several factors including increased optimism surrounding the COVID-19 outbreak, the implementation of the $1.9 trillion COVID-19 relief package and improved economic growth. These factors are also driving inflation expectations higher. While the Federal Reserve believes that a near term rise in inflation will be transitory, the bond market reflects a less sanguine outlook. Lower bond prices reflect both a return to a more normal business environment as well as an uncertain outlook regarding intermediate term inflation. Near term bond price volatility will largely reflect shifting expectations on inflation and the outlook for growth. While the markets are likely to be volatile, we expect yields to trend upwards as the economy recovers.

TAX-EXEMPT MUNICIPAL BONDS

While the battle over state and local government aid has many arguments from both sides of the political aisle, the $1.9 trillion aid package that was recently passed has many benefits for the municipal bond market. Tax-free bonds did not jump immediately upon the signing of the bill, but the stimulus provides tailwinds to an already strong market. Record demand, below average issuance, and the potential for tax increases on the horizon should lend support to municipal bond valuations.

U.S. EQUITY

The U.S. equity market remained strong last quarter fueled by the rollout of vaccines, the implementation of government aid packages, aggressive monetary policy, and a continuation of the economic expansion. In fact, high conviction in the outlook led to outperformance of some of the most cyclical segments of the market including the energy, finance and industrial sectors. This trend is also evident by looking at equity styles as large-cap value and small-cap stocks generated high returns last quarter. Looking forward, we expect the current drivers to remain in place: the economy is recovering, vaccines provide optimism for the long-term outlook and stimulus programs provide near-term financial support. These dynamics are expected to pave the way for a strong recovery in corporate earnings while also fostering an eventual economic expansion that is not reliant on stimulus programs. This is a favorable backdrop for equity investors, and we expect the market to trend upward following the recovery in corporate earnings. However, the market is likely to be more volatile as we progress through coming quarters given the strong rise in equity prices over the past year and the high valuations present in some portions of the market.

INTERNATIONAL EQUITY

International equities rallied last quarter in conjunction with the U.S. markets. Foreign economies are being driven by similar dynamics to the U.S. High levels of monetary and fiscal stimulus have been deployed in countries around the world which is helping to limit the immediate economic damage of the pandemic. In addition, the availability of vaccines will increase as we progress through 2021. The factors noted above set the stage for a strong recovery in earnings which is expected to drive foreign markets higher in the coming year. However, vaccine distribution is occurring at an uneven pace across countries worldwide. A slower rollout of vaccines in Europe, along with a resurgence of the virus, is leading to a slower rate of reopening in that part of the world and there may be other regions that suffer from similar challenges. We expect these setbacks to be short-lived, but these disparities are likely to generate volatility in returns across countries and regions. At this juncture we are maintaining a slight overweight to Asian countries and to the emerging markets.

COMMODITY

Commodity prices continued to increase last quarter given expectations for a sustained economic expansion. The gains were highest in cyclical commodities with significant increases in prices for oil and copper, but some agricultural products also participated in the rally. Looking forward, we expect commodity prices to grind higher. As the economy recovers, demand for commodities should rise and we expect price levels to move higher in sympathy.

Potential opportunities & risks

OPPORTUNITIES

New opportunities/new markets—The outbreak of COVID-19 has presented a unique set of challenges. It also provides businesses with a unique opportunity to differentiate and develop new markets. By some estimates, technology has been pulled forward two to three years and new products and services are in high demand. Prevalent themes include the increased use of technology, home improvement, home ownership, products and services that facilitate working from home, and a significant increase in the use of online retail relative to shopping in stores.

The emergence of new technologies—The convergence of cloud computing, significant increases in computing power and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes in which disruptive companies can capture high levels of market share in a relatively short period of time.

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance and transfers of cash. For example, we are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards. Electronic bill paying services and companies that facilitate cash transfers are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and the developing economies.

RISKS

Setbacks in the development of medical solutions to combat COVID-19—The rate at which vaccines have been developed is unprecedented. However, meaningful disruptions in the distribution of vaccines would be problematic as that could slow the rate at which we can return to more normal lifestyles.

Debt related issues—Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, debt has increased significantly. In the U.S., government debt increased 24 percent last year and stimulus measures adopted recently will meaningfully increase that figure.

Inflation—Given the unprecedented levels of fiscal and monetary stimulus, as well as the Federal Reserve’s policy of allowing higher rates of inflation, there is a risk that price levels may increase more than expected and be harder to contain than policy makers anticipate.

Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans and competitive practices.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We continue to monitor events across the Middle East and the South China Sea. In particular, tensions between the U.S. and China remain elevated and we are closely watching relations between the two countries.

Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.

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Published on March 31,2021