Approximately this time last year, global equities sent shockwaves through financial markets after having recently bottomed out. Fast-forward to today and most equity markets have enjoyed their fourth consecutive quarter of positive gains. A combination of continued fiscal stimulus and vaccine rollouts drove economic activity and stock market performance during the first three months of 2021. At the same time, the rebounding economic outlook began to stoke inflationary fears and worries over the willingness of central banks to respond to rising prices.
The pandemic was in deceleration mode for the majority of the first quarter, as infections, hospitalizations and fatalities declined from peak levels in January 2021. However the deceleration reversed course in the final weeks of the period due to the seeding of more virulent and transmissible COVID-19 variants. South of the border, the pace of inoculation has accelerated considerably, with the U.S. on track to stage a strong economic rebound in 2021. The country will likely become the first developed market to exceed Q4 2019 output levels this year. Meanwhile, vaccination progress in Canada, Asia, continental Europe and South America has been bumpy at best. This decoupling is likely to continue, thereby exposing certain geographies to additional economic and health risks.
As the world continues to recover from the shocks of 2020 in the months ahead, inflation is expected to rise across major developed markets, powered by a rebound in energy prices, supply shortages and tax reform. This will be most pronounced in the U.S., with their recovery already well underway. Nevertheless, the rise will likely prove transitory. Near-term price raises largely reflect short-term drivers, such as coming off a low base from last year, as well as temporary supply constraints across several sectors. We believe these temporary factors will ease in 2022, and that they do not signal the start of a more structural increase in inflation.
When it comes to inflation, half the battle is managing expectations. For example, since the 1990s, the Bank of Canada has been quite effective at anchoring business and household expectations to the 2% target. However, the high inflation rates of the 1970s and 1980s still ring in the minds of many investors. We are keeping an eye on shocks to global supply chains, as they could spark heightened, albeit short-term, inflation risks.
Last year was a reminder of the strategic role that bonds play in portfolio construction. During the harshest of equity market declines they served as a meaningful volatility dampener while generating coupon income. Though risk assets went on to stage a stunning rally from the depth of last year’s bear market, fixed income instruments still generated positive, inflation-beating returns in 2020. Unfortunately, this momentum reversed course over the first quarter of 2021.
For bond investors, concerns over resurging inflation prospects emerged over the quarter and led to a sell-off across interest-rate-sensitive markets. This took place even as the Federal Reserve and Bank of Canada reiterated their pledge of easy money policies. Treasuries and long-term government bonds were the hardest-hit sectors, followed by long corporates. High-yields were the only sector to land in positive territory over the first three months of 2021.
The recovering global economic outlook caused the yield curve to steepen substantially over the first quarter. FOMC members have not pushed back against the rise in U.S. Treasury yields, arguing it is not a cause for concern so long as the move is orderly and reflective of a brightening economic environment.
The Canadian bond universe returned -5.0% in the first three months of the year. Short-term instruments (-0.6%) significantly outperformed their long-term equivalents (-10.7%) over the period. Corporate bonds fared slightly better than their government counterparts, generating losses of -3.5% on average whereas the latter sector posted anywhere from -3.7% to -7.2% depending on duration.
Going forward, our return expectations for fixed income portfolios are muted. While we continue to believe fixed income instruments remain a critical component of portfolio construction over time, we recognize that at this point in the cycle their attractiveness has diminished. Furthermore, we continue to emphasize the importance of an actively managed fixed income portfolio in achieving long-term investment goals. Amidst a tumultuous bond market backdrop, pockets of dispersion and opportunity will be created. This scenario will favour active and alternative investment managers.
Investors who stayed the course in 2020 continued to earn positive gains from their equity portfolios during the first quarter of 2021. The pro-cyclical trade remained in favour, predicated on fiscal stimulus efforts and a vaccine-powered reopening. Once-laggard segments such as energy, financials and industrials leapt to the lead, while consumer staples, materials and the richly valued information technology sector stayed out of the limelight. In fact, technology companies closed the quarter in the unfamiliar position of weakest performing sector. Nevertheless, the gap between mega-cap IT giants and almost every other equity market sector remains wide over longer-term timeframes.
Value stocks outperformed growth companies across the market cap spectrum in Q1. Small-caps, particularly those with fortunes reliant on the recovery of the U.S. economy, continued to overtake their mid- and large-cap peers. Dividend-paying companies also performed well after lagging most of last year. Furthermore, corporate earnings results pushed markets higher on the back of numerous upward revisions.
Equity market performance was robust albeit undramatic in Q1. However, a more powerful narrative was apparent on a one-year basis, as the scale of the rebound from 2020’s market bottom became increasingly clear. The Canadian stock market led the charge last quarter, with the TSX returning 8.1% over the period and a stunning 44.3% over the past 12 months. U.S. stocks were not far behind, with the S&P 500 advancing 4.7% and 38.1% over the same timeframes, respectively. Emerging markets lagged in Q1 (+1.0%) but were another star performer on a one-year basis (+40.3%). International companies, represented by the MSCI EAFE Index, trailed their North American peers over both timeframes, appreciating 2.2% and 28.2% for the quarter and year.
Going forward, we believe the rotation towards value-oriented, cyclical companies is poised to persist in 2021. While patience has certainly been tested for value investors over the past decade, we believe they will be rewarded as the global economy and corporate earnings recover from the external shocks experienced in 2020. We believe that stronger economic and earnings growth and broad participation across sectors continue to support further equity upside.
Barring any serious return of COVID-19 infections on a global scale, we believe that stocks will deliver attractive returns during this economic expansion as they have done in previous cycles. We realize this scenario may still involve volatility and periodic pullbacks, which are normal and inevitable characteristics even in rising markets. The likelihood of market swings is not enough of a rationale for us to underweight equities at this juncture.
While our bias towards equities persists, we continue to respect the risk profiles of our clients. We have tactically positioned equity exposure at the upper end of target ranges for our clients with long investment horizons. Our clients with shorter-term horizons and/or liquidity needs continue to maintain sufficient liquidity and cash-equivalent reserves.
Our fixed income portfolios continue to favour investment-grade corporate bonds with above-average income yields backed by strong businesses. Our equity portfolios are invested in a global mix of resilient, proven business franchises. Furthermore, we retain our conviction that all client portfolios must possess balance and diversity in order to manage risk.
