This blog will serve as follow up to our previously released Q1 Investment Themes and is intended to provide an update on what we are seeing as well as our current outlook.
Here are the top three things we are covering in this week’s blog:
The Month of January was a volatile time for the equity market. After closing out a record year in 2020, investors weighed the future economic outlook and began selling early in January with the S&P down nearly 1.50% in one trading day. The dip was short lived, with a highly anticipated Stimulus bill set to be unveiled by the new administration and a robust vaccine distribution, the equity market was back to all-time highs two weeks after the start of 2021.
Looking to the latter half of January, investors began to shift their focus from a historic vaccine distribution plan and a new aid package, to a once in a lifetime battle between retail traders and a variety of heavily shorted hedge funds. With the market fixated on one of the most volatile short squeezes in recent history, the S&P managed to sell off 3.8% in just three trading days to finish the month down 1.15%.
Coming off a volatile January, investors looked beyond the short-lived GameStop saga, towards a highly anticipated earnings season. With 75% of S&P companies reporting higher than expected earnings in the 4th quarter, the overall forward sentiment was positive. But as the 10-year treasury yield began to rise, the strength of the Feds support came into question. With the bond market signaling higher yields and positive economic news, and elevating concerns of rising inflation, all eyes were locked on the UST10Y.
By Mid-February, it was clear that bond yields were not losing steam despite the Fed pledging to stay on course, sending the three major stock indexes in opposite directions. The NASDAQ saw a decline into correction territory after falling over -10% in 3 weeks. In contrast, the broader weighted Dow saw a gain of over 1%. The rotation out of technology and into value was largely due to the economic reopening, rising rates, and cheaper valuations.
In March 2021, overall market performance was largely helped by the new administration’s aid package. This new bill raised expectations on American household excess savings to roughly 50% of annual retail sales.
Of the major indexes, the S&P 500 led the charge with a QTD gain of +5.77%. Despite all the volatility, the Nasdaq 100 still managed to close +1.56% on the quarter. In contrast, surging treasury yields brought the Aggregate Bond ETF down -3.37%.
Last quarter we presented a handful of investment themes that appeared poised to outperform in Q1. Following an incredible run in the latter half of 2020, Small Caps continued to shine and finished the quarter up +12.90%. With inflation expected to reach 3% by the end of Q2, Commodities accelerated to a 4.96% gain in the first quarter. After starting off strong, Emerging Markets hit a bout of volatility that drove the index down steadily. However, a recent bounce brought the QTD return to a respectable 3.74%.
Since the start of the pandemic, we saw a major spike in unemployment and a sharp decline in GDP. During the first quarter of 2021, the unemployment rate decreased from 6.3% to 6%, adding nearly 1.4 million jobs. Additionally, GDP grew 4% as many Americans traveled back to the workplace and covid restrictions loosened.
In late January into early February, we began to see a correlation between American’s confidence around traveling and the number of vaccine doses administered.
After re-risking models in Q4, we entered Q1 confident that the market would remain strong. Despite various episodic bouts of volatility, the market performed well and closed at all-time highs.
Along with the re-risk, we also made the decision to overweight Commodities, Emerging Markets, and small cap stocks.
Q2 Investment Themes
As we discussed last quarter, our process for model management is now expanded and based on a few key areas from multiple research groups. This year, we added Hedgeye Risk Management to our team for research providers. They have added additional insight and ways to measure and map economic and market changes, and most importantly, have brought us The Quads.
The quads are all about mapping the current economic environment, as well as using predictive data to identify the probable outcome for future quarters based on an analysis of Economic Growth, Inflation and Government Policy. The quads are broken down like this:
Quad 1 – Economic Growth Accelerating, Inflation Slowing
Quad 2 – Economic Growth Accelerating, Inflation Accelerating
Quad 3 – Economic Growth Slowing, Inflation Accelerating
Quad 4 – Economic Growth Slowing, Inflation Slowing
By understanding which Quad we are in, we can identify what asset classes have historically has worked and which might struggle.
Following the success of Q1, the market enters Q2 with a Quad 2 outlook. Largely driving this are the following catalysts:
- The U.S. is expected to enter its 4th consecutive quarter in Quad 2. Much of the Quad 2 expectations are due to American mobility increasing from higher vaccine distribution and economic reopening. As a result, future economic projections may present the best YOY comparables we’ve seen in a lifetime. Alongside GDP Projections, inflation is poised for a steep increase throughout the 2nd quarter as the economic reopening is expected to take a larger effect and the Feds pledge to not control inflation even after 2%.
- Along with GDP projections, US Consumption, Manufacturing, Labor Market, and Durable goods are all going to be compared with their mediocre April 2020 lows making way for a very attractive economic report.
Despite historically positive forward economic projections, there are remaining concerns that we will be closely monitoring. Currently there is still an 8.5 million payroll deficit from the highs of last February. With so many individuals pushed out of the workforce, this deficit could have a long-term effect on the stability of the economy. As inflation continues to rise, higher prices may eventually limit the buying power for low-income earners.
Based on our analysis of the US and much of the globe being in Quad 2 (higher growth and inflation), there are investment themes that we have added to the portfolio that do well in a Quad 2 regime. Those are:
- Inflation Focused Equities & Commodities
- Industrials & Financials
- European Equities and Commodity Focused Emerging Markets
Death of the 60/40 Portfolio
Despite our optimistic outlook for the next few months, many of the tailwinds are likely to become headwinds by the end of the quarter/beginning of Q3. Even as the new administration continues to boost the economy with trillions of stimulus dollars, the unfortunate reality will finally set in that the workforce remains significantly below pre-pandemic levels. With the Fed’s current push for higher inflation, a surge in prices of necessary goods could further the wealth divide. In the case that rising inflation began to get out of hand, the Fed would be forced to make tough decisions on how to save the economy from 1970s like hyperinflation.
Over the past 40 years, a portfolio of 60% equities and 40% bonds has worked extremely well as steady economic growth and steadily lower interest rates has provided fuel to both the stock and bond market. However, if we are headed down a path of cyclical change, what has worked for the last 40 years may begin to struggle. This was on clear display in the first quarter, as a spike in the UST10Y gave way for the largest value to growth outperformance in two decades.
Over the last two decades investors have had to seek returns in other asset classes as bond yields have fallen. In 1995 you could have invested in 100% bonds and received a 7.5% annual return, compared to today where achieving the same return you’d need an 80% diversified equity portfolio. As a result, Investors are being forced to take on more risk to achieve the same level of return.
In the past few months, we have talked a lot about the mid-1990s Chicago Bulls and the inclusion of rebound legend Dennis Rodman. Despite Rodman’s inability to score, his extraordinary rebound skills provided superstars Michael Jordan and Scottie Pippen an average of six to seven extra shots per game. As a result, Rodman’s inclusion made the team virtually unbeatable and drove the offensive efficiency to one of the highest levels ever.
Just like adding Rodman to an already successful basketball duo, we believe that you should consider adding supporting asset classes to traditional portfolios to deal with the cyclical changes that are potentially coming.
There are asset classes that tend to be anti-correlated with the market and often do best when there is a lack of liquidity, when stocks are crashing, when bonds are malfunctioning, and when there are terrible credit drawdowns. When the rest of the world is drawing liquidity out of the system, these asset classes bring liquidity back into your portfolio.
Those asset classes are:
- Long Volatility
- Commodity Trend Following
- Precious Metals
Another way of looking at this is through a Zig/Zag diversifier chart. Overtime, a portfolio that combines a strong performer (Zig) with an anti-correlated long asset (Zag) significantly outperforms while avoiding major drawdowns. Combining anti-correlated assets ensures that your portfolio will have a profitable component no matter the market environment. On top of this, Zag like alternative investments serve as a “entrepreneurial put option” and provide you with liquidity when all else has dried up.
- We expect the US and much of the globe to be in Quad 2 in Q2 2021 with rising GDP and inflation.
- There are reasons to be cautious with many parts of the economy still struggling to recover and risks of the vaccine rollout being slower than expected as well as continued socio-economic tension.
- Finally, longer term, we see a larger cyclical shift coming that will require the consideration of additional asset classes beyond stocks and bonds that we will be discussing in future blogs and videos as well as upcoming meetings.
We hope you have enjoyed getting a deeper look into our investment research and look forward to providing this to you each quarter going forward. Thank you from the entire Konvergent Team!
 Slide 4: Market Jumps in Early January
 Slide 5: Market Rally Loses Steam
 Slide 6: Concerns Over Spike in Treasury Yields
 Slide 7: Major Indexes Diverge
 Slide 8: Another Stimulus Boost
 Slide 9: Major Index Performance
 Slide 10: Investment Themes Performance
 Slide 11: Unemployment and GDP
 Slide 12: Vaccine Rollout Accelerates
 Slide 13: What We Learned
 Slide 14: The Quads
 Slide 15: GDP & Inflation
 Slide 16: Soft YoY Comparisons
 Slide 17: Concerns Remain
 Slide 18: How We are Investing
 Slide 19: Historic CPI
 Slide 20: Historic Return
 Slide 21: Rolling the Dice
 Slide 22: Rodman
 Slide 23: Asset Correlation