U.S.

Stocks recorded solid gains in the first quarter, pushing all the major indexes further into record territory. The market rotation that started late in 2020 also continued, with mid- and small-caps outperforming large-caps, while value stocks easily outpaced growth shares. Sector returns varied widely. Energy shares within the S&P 500 Index recorded an overall total return (including dividends) of nearly 31% as oil prices hit their highest levels in nearly two years. Conversely, consumer staples and information technology shares returned under 2%.

Longer-term Treasury yields moved sharply higher in the quarter, with the yield on the benchmark 10-year U.S. Treasury note jumping from 0.93% to 1.74%, its highest level since early 2020. (Bond prices and yields move in opposite directions.) High yield corporate securities managed a modest positive return, thanks to favorable corporate earnings and higher coupons. Municipals also proved relatively resilient as investors welcomed increased federal support for state and local finances.

New Relief Package Spurs Both Growth Hopes and Inflation Fears

New stimulus measures fueled both growth hopes and worries about potential inflation, driving the rise in yields. To the surprise of many, the Democratic Party gained control of the Senate after special elections in Georgia in January. Stocks rose as it quickly became clear that President Joe Biden would use his party’s unified control of Congress to push through a new coronavirus relief package that was much larger than Republicans had proposed. The president signed the USD 1.9 trillion American Rescue Plan Act into law on March 14, and direct payments of USD 1,400 to most Americans began hitting bank accounts shortly thereafter. 

The accelerated vaccine rollout seemed to provide a further boost to confidence. In the middle of the quarter, President Biden said that he expected all Americans to have access to a coronavirus vaccine by July, which he soon revised to May 1. By the end of March, nearly one-third of Americans had received their first dose. Case reports and hospitalizations began to fall sharply in late January, although the decline seemed to plateau late in the quarter. 

Job Growth Resumes as Third Wave Abates

As the third wave of the virus abated, many states began to reopen partially or even fully—often against the advice of health officials. As they did, hiring resumed, particularly in the hospitality and leisure industry. After falling in December for the first time since April, monthly payrolls registered gains in January and February, and weekly unemployment claims hit pandemic-era lows. Manufacturing and housing signals remained strong, although severe winter weather and the near collapse of the Texas power grid in February slowed growth temporarily. 

The economic rebound and lingering supply chain bottlenecks led to price pressures in some parts of the economy, but overall inflation data remained muted. The core (excluding food and energy) personal consumption expenditures index increased by 1.4% year over year in February, down from 1.5% in January and still well below the Federal Reserve’s 2% inflation target. Both Fed Chair Jerome Powell and Treasury Secretary Janet Yellen testified before Congress that they saw little danger of an overheating economy.

Some argued that inflation was more pronounced in asset prices. A “short squeeze” organized on social media led to rapid increases in some thinly traded shares in late January and briefly seemed to spur volatility in the broader market. Money also flowed into special purpose acquisition companies (SPACs)— investment pools with no declared acquisition targets—while the price of the cryptocurrency Bitcoin roughly doubled over the period.

Europe

Shares in Europe posted a fourth consecutive quarter of gains, as optimism about economic growth eclipsed uncertainty stemming from renewed coronavirus-related lockdowns. Core eurozone bond yields climbed on investor expectations of accelerating inflation, which also triggered a strong market rotation from growth stocks into value-oriented fare. 

Europe Tightens Restrictions; Vaccine Tensions Rise 

An increase in coronavirus infection forced France to impose a third, month-long nationwide lockdown. Germany and Italy also extended their pandemic-related restrictions into April, and Belgium tightened its limits on activity. European Union (EU) leaders, concerned about vaccine shortages, agreed to strengthen export controls on vaccines made in the EU. The European Commission threatened to block exports unless other countries supplied the EU with vaccines—a threat aimed particularly at the UK, whose inoculation campaign is further along. Italy, however, stopped vaccine exports to Australia, Germany, and France. Italy also restricted the distribution of the Oxford-AstraZeneca vaccine to certain age groups, citing the risk of cerebral blood clots, but the bloc’s medical regulator said it was safe and urged that the vaccine be deployed rapidly. 

ECB, BoE Maintain Support; Economy Appears Resilient

Partly to support the economy and to ensure favorable financing conditions threatened by rising bond yields, the European Central Bank (ECB) left its key interest rates unchanged and announced it will step up the pace of bond purchases. Even so, the ECB raised its 2021 forecast for eurozone economic growth to 4%, from its 3.9% estimate in December. It also expects inflation to reach 1.5%, up from 1%, due to temporary factors and higher energy prices. Official data showed that eurozone inflation quickened in March to 1.3% from 0.9% in February. Business activity unexpectedly grew in March, driven by the fastest expansion in manufacturing in 23 years, a purchasing managers’ survey showed. But many economists expect overall activity to slow again due to the tightening of coronavirus restrictions. 

The Bank of England left monetary policy unchanged, maintaining its bond-buying program and its lowest-ever key rate of 0.1%. UK economic output shrank 2.9% sequentially in January due to a sharp slowdown in the services sector. Economists in a Reuters survey had forecast a 4.9% contraction. However, UK exports to the EU in January, the first month after Brexit, fell 40.7% compared with December. UK imports from the EU tumbled 28.8%. 

Draghi Anointed as Italy’s New PM; Political Uncertainty in the Netherlands

The Italian coalition government led by Prime Minister Giuseppe Conte fell after a disagreement over plans for spending EU rescue funds prompted the Italia Viva party of former premier Matteo Renzi to withdraw its support. After a consultation process, Mario Draghi, the former president of the ECB, emerged as his successor, and his new unity government subsequently received overwhelming parliamentary support. In the Netherlands, Mark Rutte, leader of the center-right VVD, won a fourth election after his previous coalition government resigned over a child-care subsidies scandal. There are signs that he may struggle to secure a parliamentary majority.

Japan

Japanese stocks produced strong gains in local terms during the first quarter, outperforming within the Pacific region and versus the global developed market universe, although a sharp drop in the yen reduced returns for foreign investors. From a style perspective, as measured by the MSCI Japan Index, value stocks outperformed growth shares handily, while small‑caps provided superior gains to their larger-company counterparts. The yen closed the quarter at 110.5 versus the U.S. dollar, the highest (weakest) level in a year. The yield on 10-year Japanese government bonds moved higher over the period, ending the quarter at 0.098%. 

Record Market Highs as Further Stimulus Underpins Confidence

Having pushed past the 27,000 mark for the first time since 1990 in the fourth quarter of 2020, the widely watched Nikkei 225 Average continued its northward journey in the first quarter of 2021, setting numerous multi-decade highs before ending the period comfortably beyond 29,000 points. 

Significant stimulus measures ultimately underpinned investor confidence during the quarter. Early on, the Japanese government acted swiftly to try to curb a potential third wave of coronavirus infections, agreeing to a third supplementary budget in January to the tune of JPY 19 trillion (USD 185 billion). This was officially ratified in March, with the Japanese Diet approving a record JPY 106.61 trillion (USD 976 billion) budget for the 2021 fiscal year (commencing April 1), aimed at helping to mitigate the fallout from the coronavirus pandemic as well as rising social security and defense costs. The monetary policy committee also increased Japan’s economic growth target for fiscal 2021 from 3.6% to 3.9%, mainly due to the aggressive stimulus efforts.

Improving Sentiment Also Evident Among Business Leaders

The positive sentiment was similarly reflected among Japan’s business leaders. For the first time since mid-2019, the February monthly Tankan Index recorded a positive reading among manufacturers. The poll, which closely tracks the Bank of Japan’s (BoJ) quarterly Tankan Index, showed that Japan’s manufacturers in aggregate were more positive than negative on business prospects, thanks, in part, to expectations of improving overseas demand. 

Fears of a Delayed Economic Reopening Prompt Some Volatility 

A combination of renewed coronavirus fears and some weak economic readings caused some volatility late in the quarter. News of a third wave of coronavirus lockdowns in some European countries dented hopes of a broad economic reopening, causing Japanese equities to drop sharply in March. Subsequent reports that the weekly number of new coronavirus cases in Japan exceeded 10,000 for the first time in six weeks only added to investor concerns. 

Meanwhile, economic data disappointed late in the quarter as the total value of Japanese retail sales fell by an annual rate of 1.5% in February, while industrial production was also down by a seasonally adjusted 2.1% in February, month on month, exceeding the anticipated 1.2% decline. This was particularly disappointing given the 4.3% jump recorded in January. Elsewhere, Japanese unemployment came in at a seasonally adjusted 2.9% in February, unchanged from the January reading. 

Japanese equities rallied late in the period, however, following the announcement by U.S. President Joe Biden of a more than USD 2 trillion infrastructure spending plan at the end of March. This inspired renewed hopes for a potential stimulus-driven global economic recovery.

BoJ Revises Policy

The BoJ published a long-awaited review of its policy tools following its March 18–19 monetary policy meeting, introducing slight tweaks with a view to keeping easing measures in place for a prolonged period. It removed its guidance to buy exchange-traded funds at a set pace: Under the new policy, it will intervene only when necessary, rather than steadily increasing its holdings, while maintaining a JPY 12 trillion ceiling for annual purchases. 

While the BoJ deemed it appropriate to continue with yield curve control, it added some flexibility, stating that the range of Japanese government bond yield fluctuations would be around plus or minus 0.25% from the target level of around zero. The range was increased slightly from 0.2%. The BoJ also plans to offer incentives for financial institutions that borrow from its various lending programs to mitigate the side effects of additional interest rate cuts. It reiterated that short- and long-term policy rates are expected to remain at present or lower levels.

China

Chinese shares posted a quarterly loss after peaking in mid-February. The Shanghai Composite Index declined 0.9%, while the large-cap CSI 300 Index lost 3.1% due to its heavier technology weighting. Volatile global markets and the rise in U.S. Treasury yields were among the headwinds that contributed to the quarter’s declines. Shares of China’s online leaders Alibaba, Baidu, and Tencent fell amid heightened government scrutiny of the internet sector. Technology stocks came under renewed pressure at quarter-end after the Securities and Exchange Commission said it would start to implement a law passed by the Trump administration to delist U.S.-listed Chinese companies that do not comply with U.S. audit requirements. Looking ahead, analysts see China’s market as becoming more earnings-driven this year after a solid post-pandemic economic recovery. Corporate earnings for 2021 are expected to increase 23% for the MSCI China Index and 20% for the CSI 300 A-share Index, with more modest increases forecast for 2022, according to analysts’ estimates compiled by database I/B/E/S.

China’s relatively high bond yields and low correlation to other bond markets continued to draw strong investment inflows. The yield on the 10-year China government bond peaked at 3.36% on March 5 before declining to end the quarter at 3.20%. The People’s Bank of China left interest rates unchanged over the quarter. In March, FTSE Russell confirmed that it would include China in its World Government Bond Index during a three-year phase-in from November 2021 to October 2024. In currency markets, the renminbi weakened 0.35% against the U.S. dollar to close at 6.553 in a low-volatility quarter. 

NPC Scales Back Stimulus 

In a bid to promote more sustainable growth and prevent China’s economy from overheating, lawmakers at the National People’s Congress (NPC) in March issued relatively conservative monetary and fiscal policies. Beijing set a gross domestic product (GDP) growth target of more than 6% for 2021, a level seen as easily achievable given last year’s pandemic-depressed economy. Beijing also projected that China’s budget deficit would fall to 3.2% of GDP, reflecting a renewed focus on curbing debt but disappointing local investors who had hoped for fresh stimulus.

Data Indicate Solid Recovery 

Due to the timing of the weeklong Lunar New Year holiday, China reported economic data for January and February combined in March. However, this year’s data proved difficult to interpret due to the low base in 2020 and the pandemic’s varied impact on sectors. In response, government statisticians adopted a two-year comparison, which revealed strength in exports and manufacturing but weaker recoveries in retail sales and investment. The official March purchasing manufacturing indexes for manufacturing and services showed broad-based improvement. Industrial profits also showed strong growth and suggested that Chinese industry is much better positioned than it was a year ago.

After containing a third wave of coronavirus infections in January with partial lockdowns, China continued to report a small number of new coronavirus cases daily. Beijing has pledged to vaccinate 40% of the country’s population by the end of June. If successful, analysts believe the plan could position China’s economy for a strong rebound in business and consumer services.

Other Key Markets

External Factors and Domestic Developments Weigh on Brazilian Stocks

Stocks in Brazil, as measured by MSCI, returned -9.93% in U.S. dollar terms versus 2.34% for the MSCI Emerging Markets Index. Brazilian assets, including its currency, were pressured by external factors, such as rising U.S. Treasury yields and a stronger U.S. dollar. The market was also hurt by domestic developments, including the rapid spread of a coronavirus variant that has overwhelmed hospital capacity and led to significant new lockdowns and the government’s struggle to provide more pandemic-related financial support while observing the country’s mandatory spending cap.

One of the largest factors that weighed on Brazilian assets was an increase in inflation that prompted central bank officials to stop providing forward guidance on how long they expect monetary policy to remain stimulative. According to the minutes of the January 19–20 meeting, some policymakers “questioned whether it would still be appropriate to maintain an extraordinarily high degree of stimulus,” while others suggested that the central bank “should consider starting a process of partial normalization” of interest rates.

In mid-March, policymakers increased the benchmark Selic rate from an all-time low of 2.00% to 2.75% and signaled that another 75-basis-point (0.75%) rate increase was likely at their next meeting on May 4–5. While they observed that GDP at the end of 2020 was strong and that inflation forecasts were picking up, they also acknowledged that there were still risks to the economy from the coronavirus. T. Rowe Price sovereign analyst Richard Hall believes that the rate hike was the right decision, as it will help anchor the currency and reduce inflation expectations.

Stocks Drop Sharply in Turkey

Turkish stocks, as measured by MSCI, returned -20.17% in U.S. dollar terms and significantly underperformed the MSCI Emerging Markets Index.

Turkish assets, including the lira, struggled amid rising U.S. Treasury yields and a stronger U.S. dollar versus the lira. Late in the quarter, Turkey’s financial markets were rocked by news that President Recep Tayyip Erdoğan was replacing the central bank’s governor, Naci Ağbal, with Şahap Kavcıoğlu, an AKP Party loyalist who, like Erdoğan, favors unorthodox economic policies. Kavcıoğlu is Turkey’s fourth central bank governor in the last two years; his appointment took place just a couple of days after Turkey’s central bank raised its key one-week repo auction rate from 17% to 19%.

Regarding a possible policy shift under the new central bank governor, T. Rowe Price sovereign analyst Peter Botoucharov believes that there will be no near-term change in monetary policy or imposition of capital controls in view of the country’s macroeconomic challenges, high financing needs, and low level of foreign exchange reserves. Kavcıoğlu, as part of his appointment process, spoke before Turkey’s General Assembly and tried to assure lawmakers that a tight monetary stance is needed at present and that the central bank will continue to use its monetary tools effectively. However, Botoucharov believes that there is a risk of a faster monetary policy reversal later this year, given preferences for growth and low real (inflation-adjusted) interest rates.

Botoucharov’s greater concern is whether Turkey will be able to rebuild investors’ confidence in macroeconomic policymaking over the medium term. The change in central bank leadership was likely driven by both broader political considerations ahead of an expected government reshuffle and an AKP Party symposium on March 24. Given President Erdoğan’s disagreement with a policy of high real rates, Botoucharov is uncertain about Turkey’s commitment to a sustained policy adjustment over the medium term. He believes that the new central bank governor could return to unorthodox monetary policy measures.

What We’re Watching Next

The market’s recovery has been swift and dramatic. We’ve transitioned from a period in March 2020 that was full of fear into a period, now, where speculation seems to be rampant and valuations by many measures, are historically high. We’re not quite in a bubble, in my view, but valuations, are expensive under all but the most optimistic scenarios. Current conditions can persist for a while, but sustained gains will be harder to identify. 

So, where do we go from here as investors? Broadly, there are four key themes we’re watching. First, we think it will be an uneven road to recovery, meaning there will be periods of volatility as we get back to a new normal and especially as much of the recovery has been priced into markets. Second, politics and the Biden administration’s emerging priorities will remain in the spotlight. Third, investors will need to be creative as they search for yield in this low rate environment. Fourth, disruption caused by new technologies will continue, which in turn should create style dispersions, such as we’ve seen recently with stronger returns in value stocks, in particular.

It’s a time to be careful, as there are clear signs of speculation in markets. The rapid rise of cryptocurrencies and capital formation through less conventional vehicles are two that have my attention.

One key risk that we’re watching: signs of inflation. It’s hard to know when the current regime will end, but if inflation rises meaningfully, it will be a whole new environment for financial markets.

The one thing we can say is that we won’t have continued disinflation in the near term. Longer term, markets will no longer have the tailwind of falling rates, although they could remain at historically low levels if the inflation impulse fades. 

Four risks—both downside and upside—that we’re watching in addition to the eventual end of the accommodative monetary era:

• Geopolitical hot spots that grabbed headlines in early 2020 have been bumped from the front page, but they have not disappeared.
• What happens to tax rates will be front and center, including the potential for higher corporate rates and tax rates on dividends for individuals.
• The U.S.‑China trade war might intensify or establish new fronts.
• The Biden administration may prove less market-friendly, but some cabinet appointments, such as Janet Yellen as Treasury secretary, point to moderation.