In part two and part four of this series, we discussed the sweeping fiscal and monetary support that was provided to the global economy in response to the pandemic. This support has led to higher consumer savings and, predictably, high pent-up demand for goods and services, which may rise to the surface as the world pushes closer to normalcy with the progress of vaccination efforts. In addition, stimulus measures—including supportive monetary policy and the prospect of ramped-up government spending—provide a backdrop that should continue to fuel the economy. Some market participants have voiced that all of these factors combined may be too much of a good thing, and may eventually lead to inflationary effects. These concerns may be causing investors to question how they should best position their investment portfolios. In part four, the conversation was focused on bond markets. We will now shift the attention to the stock market.

To provide a brief recap, the big story in 2020 was the magnitude and speed of the stock market decline and subsequent recovery. Government and central bank support played a significant role in shoring-up the economy and reassuring investors. That said, not all stocks were winners and certain sectors fared much better than others. Growth stocks—including Internet and technology companies—delivered the strongest returns, while more value-oriented stocks—including financials, energy and real estate—declined. 

The US technology sector in particular benefited significantly from restrictions and society moving online. This contributed to a large appreciation in company valuations and stock prices, which led to the broad sector returns exceeding 40 per cent for the year. On the other end of the spectrum, the US energy sector slumped nearly 34 per cent as global energy demand dried up, causing energy prices to crater.

A bit of a different story has been unfolding so far in 2021. Though all sectors of the broad US market have performed well so far, the top performers now include the less-favored value stocks of 2020, while former high-flying growth stocks lag. US value stocks have outperformed growth stocks by 9.5 per cent year-to-date as of the end of May, which is in stark contrast to growth’s outperformance of 32 per cent in 2020.

What was the cause of this trend reversal? It’s difficult to say with certainty, but one driver could have been that investors have been taking some profit off the table and rotating into the hardest hit and depressed sectors—such as energy, basic materials, real estate and financials—that may be well-poised for growth as the economy continues to reopen. 

Timing the market with the gift of hindsight

It’s a lot easier to explain the drivers that may have contributed to an investment gain after the fact. For example, the sharp recovery in the energy sector was likely not as intuitive to predict as one may have thought. Increased oil prices benefitted the sector, and were attributed partially to unforeseen Middle Eastern supply disruptions and hostile geopolitical conditions. Additionally, continued supply control from the Organization of the Petroleum Exporting Countries (OPEC) also helped support rising prices, even as demand remained depressed from reduced leisure and business travel.

The materials and industrial sectors may have benefited from the likelihood of future government infrastructure spending increases, and from the increased demand for a variety of raw materials (iron, gold, silver etc.) used to make products sought after by consumers with increased savings. In many cases, increased prices for such commodities seem to be driven by a combination of increased demand and decreased supply stemming from supply chain interruptions caused by the pandemic.

In addition, the last two quarters of earnings reports in 2021 from “Big Tech” (Apple, Alphabet, Facebook etc.) were extremely strong across the board, with the companies vastly outpacing stock analyst expectations for revenue, margins and earnings per share. Surprisingly, many of these companies saw their stocks fall significantly after boasting these record-breaking earnings reports, which was unexpected. This was not limited to the technology sector either. Car companies—such as Ford, Tesla and GM—had seen record demand, but they weren't able to produce enough vehicles to meet that demand amidst massive supply chain shortages (semiconductors in particular). These shortages were another one of those uncontrollable factors that make stock market timing challenging, if not impossible.

What about inflation?

As discussed in previous articles of this series, the low interest rate environment, significant government spending, and apparent glut of consumer savings waiting to be spent, have the potential to support increasing inflation. That said, inflation has eluded market participants and academics for years now and is far from being an inevitability. If inflation does rise and ends up being more of a long-term trend—rather than short-term and transitory as many central banks suggest—how will this affect stocks?

Historically speaking, stocks have delivered returns that have exceeded inflation. The S&P 500 returned investors an average of 9.8 per cent per year from 1928-2020, while inflation averaged roughly three per cent. This means that US stocks had outpaced inflation by nearly seven per cent over the long term. Stocks have also generally experienced positive returns during periods of rising inflation but their average returns over such periods have been somewhat muted. Over the same timeframe of 1928-2020, the average annual return for the S&P 500 was 6.7 per cent when rates were increasing¹. 

Part of the reason why stocks have the ability to deliver growth during inflationary periods is that companies, in many cases, can pass on increasing costs to their customers. This is most true for quality companies with distinct competitive advantages that allow them greater ability to adjust prices to lessen the impact to their bottom lines. Furthermore, the very factors that are purported to be a risk of increasing inflation also tend to increase economic activity and growth, which usually support stock prices.

For example, let’s take a look at company earnings, which are expected to be a large beneficiary of the forecasted influx of cash into the economy from stimulus measures, excess consumer savings and demand. These higher expected future earnings have led to higher stock prices overall. As shown in the following table, 2021 is expected to make a full recovery from 2019 earnings levels. Those earnings will also be surpassed by a meaningful amount with strong growth anticipated for 2022.

Source: Bloomberg

Final thoughts

Successfully predicting the events of the future, as well as how the components of a portfolio will react, is not a strategy that tends to work out with consistency. Fortunately, investors do not need to determine which style—value or growth—will outperform in a given year, nor do they need to concern themselves over which sectors will post the largest gains or to what degree inflation may or may not appear. Rather, investment success can be found in establishing and maintaining a long-term strategy that includes holding a diversified portfolio with an appropriate asset mix.