Q1 2021 - Market Review

ECONOMIC COMMENTARY

After an encouraging decline in new COVID-19 cases in the weeks following the winter holidays, the number of new cases started to increase again from the middle of February as new variants, which are proving to be more contagious than the original strain, are rapidly becoming dominant globally. Yet, fueled by the promise of accelerated vaccine rollout strategies and sustained monetary and fiscal support, global equity markets recorded healthy gains during the quarter. In fact, the MSCI All Countries World Index[1], S&P 500 Index and S&P TSX Composite Index rose 5.85%, 6.18% and 8.05%, respectively.

As has been the case since the announcement of the promising Pfizer and BioNtech SE, the performance of value stocks easily outpaced the performance of growth stocks. For instance, the MSCI World Value Index recorded a gain of 9.56% while the MSCI World Growth Index recorded a gain of only 0.24%. Interestingly, value stocks, which had underperformed growth stocks by a margin exceeding 30% in the first 9 months of 2020, have outperformed growth stocks by nearly 15% from September 30, 2020, to March 31, 2021. This was the best relative performance of value stocks overgrowth stocks for a 6-month period since September 2000, 6 months following the dot.com bubble implosion. For those intent on buying growth stocks after the recent weakness, we urge circumspection as we don’t think that the specter of targeted taxation and anti-trust legislation against the Silicon Valley information technology and communication giants are fully priced in.

Fixed income markets were equally dispersed. To this point, higher growth and inflation expectations became consensual after Federal Reserve Chairman Jerome Powell reasserted that the institution would not lift rates until the United States approached full employment and that it was prepared to tolerate above guideline inflation to reach this objective. This caused the United States interest rate curve – measured by the difference between the yield to maturity on 10-year government notes and the yield to maturity on 2-year government notes – to steepen by 0.80% during the quarter as interest rates on longer term maturity bonds moved firmly higher. This caused the ICE Bank of America Merrill Lynch US Corporate & Government Bond Index to depreciate by 4.43% during the quarter. The impact of higher rates on longer-term interest rates was particularly detrimental to bonds with more than 10 years left before expiration as the ICE Bank of America Merrill Lynch US 10+ year Broad Market Bond Index lost 10.76%, it worst quarterly performance since the 3rd quarter of 1980. In contrast, the ICE Bank of America Merrill Lynch Global High Yield Index posted a return of 0.67% during the quarter on improved growth prospects.

Commodities, as proxied by the S&P GSCI Index, have gained 30.00% from September 30, 2020, to March 31, 2021, including a gain of 13.55% during the first quarter. To put this performance in perspective, the commodities had lost one third of their value in the first 9 months of 2020. The reversal was fueled by a combination of improved demand fundamentals and fear of shortages.

HIBERNATING INFLATION

With the first signs of spring and the Producer Price Index (PPI) increase by 4.2% from April 2020 to March 2021, its largest annual gain in more than 9 years[2], there are growing concerns that inflation may come out of a 40-year hibernation.

Broadly speaking, we are not particularly worried about inflation. Headline measures have been rising over the last 12 months, but it is a function of the decline in prices that occurred a year ago as a result of government-mandated shutdowns which caused a sudden collapse in aggregate demand for many goods and services. In other words, the recent increase in inflation appears to be transitional, not structural. Importantly, such a view does not differ from consensus.

If inflation is not an imminent threat, does that mean that it is time to reconsider long-term government and corporate investment grade bonds? The short answer is that we do not think so. From our perspective, the risk reward on this segment of the fixed income market has merely gone from extremely negative to somewhat less negative because even after the recent increase in yields to maturity, nominal yields still do not cover long-term inflation rate expectations.

Does that mean that the threat of inflation has been eliminated permanently? We do not think so either. In our opinion, inflation is more likely to be awakened by the exhaustion of the pool of inexpensive labor available in countries like China, Malaysia and Vietnam, where most of the world’s goods are now being manufactured and imported from. In fact, if workers in Third World countries were to acquire bargaining power that exceeds the pace at which automation pressures occur, we believe it would represent a more serious structural inflationary risk than most other factors because it would be a reversal of an offshoring trend that started in the 1950s. That said, these are the kind of developments that take place over the long term. For this reason, we think inflation will remain in hibernation a little longer.

THE GAME THAT WOULD NOT STOP

During the quarter, the common shares of GameStop, a US-headquartered specialty retailer of video game console and accessories, appreciated by over 1,000% from the December 31st closing price. Intriguingly, the phenomenal surge in GameStop share price had little to do with the company’s fundamentals. Instead, it started in an online forum where non-professional and semi-professional investors assemble to discuss investment ideas. There, individuals like Keith Patrick Gill[3], under the guise of multiple use accounts and pseudonyms, orchestrated a wildly successful social media campaign to drive up the value GameStop’s shares and “squeeze”[4] short sellers.

What transpired from the majority of users’ posts was their outright rejection of the financial system in a way that was reminiscent of the #Occupy narrative which started a decade ago. The difference here is that peaceful protests were replaced by a concerted effort to weaponize the system’s tools and apparatus against itself.

As long as the world is awash in liquidity and borrowing costs stay near record lows, volatility spikes can be triggered anywhere and spectacular price movements like those witnessed in the GameStop saga may not be dismissed as isolated incidents. At Patrimonica, when conducting due diligence on a fund that may be on the other side of a highly controversial situation, we are particularly attentive to the risks associated with excessive leverage and portfolio concentration.

[1] Index returns refer to the net total return series in local currency terms, unless specified otherwise.

[2] Source: Bureau of Labor Statistics

[3] Gill’s profile was raised further after he was asked to testify to the House Committee on Financial Services on February 18, 2021. Two days earlier, Gill had been named as one of the defendants in a class-action lawsuit for violations of the US Securities Code.

[4] A situation where those who have taken a short position on the price of a stock are obligated to purchase the stock on the open market, facilitating a scramble to purchase shares, resulting in a sharp upward pressure on the stock’s price.