In his 2004 book, The Misbehavior of Markets, mathematician and inventor of fractal geometry Benoit Mandelbrot succinctly illustrates how market crashes happen more frequently than modern portfolio theory would suggest. We expect volatility from the equity market, but some of the precipitous declines experienced by investors over the past three decades are just not supposed to happen. Markets are riskier than our widely accepted models suggest, Mandelbrot preaches.
The first quarter of 2021 will be remembered as a period when the fixed income markets misbehaved, dropping by 5.04%. A bond market decline of this magnitude last happened in the first quarter of 1994, when the U.S. Federal Reserve unexpectedly started a series of short-term interest rate increases. Going back further, over the past 160 quarters, a drop of more than 5% in a quarter has actually happened four times. Just as with equity markets, this rare drop hasn’t been as rare as a simple “standard deviation” model would suggest.
Similarly to 1994, currently we have accelerating economic growth and rising inflation expectations, and although the reasons may be drastically different, equity markets typically do very well in such an environment. With massive monetary and fiscal stimulus supported by selected re-openings and vaccination roll-outs across the globe, year-over-year economic growth to the end of March was very strong.
Economically sensitive areas led the way once again, continuing their run of performance that started last November. Energy, Financials, Materials, and Industrials were among the top-performing sectors across markets. Similarly, with more exposure to the areas poised to benefit during a sustained economic recovery, value stocks outperformed growth stocks.
The Canadian equity market and Canadian dollar both had a strong quarter, as one would expect when there is strength from the commodity complex. The S&P/TSX Composite Index advanced 8.1%. Oil prices increased 23%, which resulted in energy producers being one of the top-performing segments of the Canadian equity market. On the flip side, despite its reputation as an inflation hedge, gold performed poorly; expectations of rising real interest rates took the shine off the yellow metal for the time being.
Globally, the MSCI All Country World Index gained 6.0% (+3.3% in Canadian dollar terms). U.S. technology stocks – a key driver of the index for some time – struggled in the face of rising interest rates (companies with cash flows further out in the future can be negatively impacted by higher discount rates). Emerging markets lagged their developed counterparts.
Going forward, the word most often heard amongst analysts is “transitory.” That is, will accelerating growth and inflation be transitory due to easy year-over-year comparables? Or are there structural and policy issues afoot which may result in inflation being higher for longer? Experienced and well-respected macro strategists argue both sides. As always, time will tell.