The global pandemic was a central theme this quarter; going back to the beginning of the year, we can see that there's been a significant drop in the number of cases, which has helped in the reopening. There's also the optimism of the COVID vaccine, whether it's Pfizer, Moderna, or Johnson & Johnson.
As the susceptible population drops, the severity of the outbreaks decline. There is a possible third wave in early Spring, but not as severe as more medical intervention options become available.
Change in Leadership
One theme that also dominated market trends in the first quarter - just as it did in Washington D.C. was a change in leadership leading to government spending and tax changes. President Joe Biden was announced as the 46th President of the United States on January 20, 2021.
President Biden called for returning the top marginal rate to 39.6%, the same rate when President George W. Bush, a Republican, was in office. The 2017 tax cut reduced that rate to 37%. Under Biden's campaign tax proposal, those annually earning more than $1 million would have to pay higher taxes on capital gains, which typically make up the largest share of income for the wealthy. He would require estates to pay taxes on the unrealized gains on these assets.
As part of his campaign platform, Biden wanted to subject wages of more than $400,000 to Social Security payroll tax, currently capped at $142,800 for 2021. Ultimately he would rewind the estate tax policy to 2009 when the federal exemption was $3.5 million per person, and the rate was 45%. Biden would also reverse part of the 2017 tax cuts to the corporate income tax rate. He would increase it to 28%, up from the current 21%, but not as high as the 35% top rate before the Republican tax breaks.
As tax proposals change, government spending does as well. Biden proposed a $2 trillion bill on infrastructure and jobs. The plan includes everything from road repairs and electric vehicle stations to public school upgrades and training for the clean-energy workforce.
U.S. Deficit Spending is Accelerating the National Debt
Because the infrastructure bill is so high, it will impact the national debt vs. Gross Domestic Product (GDP). All of the Government spendings are starting to show up in statistics and is a concern. The blue line is the national debt. It has continued to increase over the last year. If you look at GDP, the red line, you can see that the debt is outpacing GDP by far. These numbers and the relationship between one another are essential to pay attention to due to inflation.
We know the inflation fears exist because people are no longer saying that we won't have inflation, and we already see the signs of inflation in the graphs below.
The left graph represents the first quarter of 2021 and looks at several U.S. stock market indexes vs. several commodity indexes. Commodities for the quarter have significantly outpaced the stock market indexes. We can also see a similar trend where everything is based on the Dow Jones Industrial Average. The NASDAQ was up more than 9% above the Dow. However, it was nothing compared to the energy index, which was up 20% over the Dow.
Crowding Out Effect
The Government is pulling resources by spending and increasing prices by bidding up, known as Cost Pull. They then decide what investments to make and taxing corporations that reduce their ability to invest in growth (reducing long-term private-sector production). It is not just in the price of things; we see it in the bond market as well.
We see inflation expectations in rising yields between 3-3.2%. Inflation is not something that the government isn't aware of. It's something that they are pursuing as a policy, another theme we see in the 1st quarter.
For bonds, the first quarter of 2021 was at its worst in over 40 years. The bond sell-off hit treasuries the hardest, followed by safer core and corporate bonds. Only high-yield bonds managed to end the quarter in positive territory.
Perhaps the most notable change was strength in value stocks, which have been lagging significantly in recent years. Still, the longer-term performance gaps are in favor of growth stock. Long duration is not just a concept in fixed income; it's a concept in stocks. Stocks that are long duration tend to be growth or technology.
In the Image above we can see the long duration effect on returns. Changes in the discount rate will have a larger impact on Growth than Value and Large cap compared to small cap. There are always other factors to consider, but this showed up for the first quarter. US Large Cap Growth was negative .73%, while Large Value was a strong 10.13%. Small Value was 21.41% while, Small Growth was negative .42%. For the first quarter, the further down market cap and to the value side, the better the performance. This is not the case over the 1 and 3 year time periods. Over the last year, you wanted to be Small with a Growth tilt and over 3 years Large with a Growth tilt. Is this the start of a new rotation away from Growth stocks? This has yet to be determined.
The broadening of recovery and rising interest rates boosted cyclical stock sectors during the quarter. Energy stocks gained 31%, and financial services and basic material companies led all other sectors. Defensive sectors suffered, and technology stocks gained the least of any sector for the first time since 2016.
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