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A head-fake first quarter?

April 01, 2021

Graph depicting largest declines in the Barclays aggregate total return index

Source: Barclays

The first quarter was in broad strokes a replay of the back half of 2020, as the economy continued to recover and risk assets again moved up at a solid clip. There were major shifts within the markets in the first three months of the year, however, at least some of which may not prove to be so lasting.

Most notably — and influentially — long-term rates shot up in Q1, with the 10-year Treasury yield jumping by 80 basis points and hitting a 14-month high in the process. As a result, the Barclays Agg fell for the first time since the second quarter of 2018 and by the most on a sequential basis since the third quarter of 1981. As we have noted several times in this space, though, it would be unusual for yields to continue climbing in the absence of Federal Reserve rate hikes. In fact, the Barclays benchmark index has moved lower in back-to-back quarters just nine times in its more than four-decade history, with only one of these occurring outside of a Fed tightening cycle (the 2013 ‘taper tantrum’). With monetary policymakers continuing to vehemently stress that rate hikes are unlikely for at least a few more years, it is a good bet that the sell-off that gathered steam in the first three months of the year won’t be especially long-lived.

If this proves correct, it is also likely that the growth side of the equity market will resume its leadership position. Value outperformed significantly in the first quarter, in part on re-opening optimism but also driven to a large degree by the surge in long-term yields (growth stocks are, on balance, longer-duration assets). While growth has historically tended to outperform in the middle-to-latter stages of the economic cycle, it would come as little surprise should the accelerated nature of this expansion, ongoing monetary stimulus, renewed techno-optimism, and the still-developing boom in retail participation pull this dynamic forward.

There was also a bit of a rotation by market cap in Q1, as small cap stocks underperformed in March after outpacing larger firm shares in each of the prior six months. Small cap outperformance in the early stages of this cycle was substantial — the Russell 2000 rose by 90.9 percent between March 2020 and February 2021 versus 52.4 percent for the Russell 1000 — but this is very much in keeping with the historical trend and not at all a harbinger of a lasting reversal. Small caps tend to outperform deep into economic cycles and, on this front at least, there are fundamental reasons to expect that the longstanding tendency will hold here. U.S. economic growth appears poised to remain solid well beyond 2021 and, given the discrepancies in vaccine distribution and stimulus, it could be some time before the global growth that disproportionately benefits large caps catches up.

There were, of course, many trends over the last three months that were continuations of the patterns in 2020 and that are likely to be sustained further going forward (a rapidly improving labor market, rising commodity prices, etc.), but some of the more conspicuous developments thus far in 2021 still look more like head fakes than the establishment of new cyclical narratives.rising commodity prices, etc.), but some of the more conspicuous developments thus far in 2021 still look more like head fakes than the establishment of new cyclical narratives.

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