The surprising Democratic sweep in Georgia’s Senate runoff races, all but assuring continued massive fiscal stimulus, set the tone early in the quarter, as cyclical recovery plays continued their market dominance. Stocks of nearly all styles, sizes, geographies, and sectors posted gains in the quarter. The positive market drivers have remained rather intact for just about a year now: aggressive fiscal and monetary stimulus, vaccine development/deployment, and economic reopening leading to surprisingly strong and accelerating profit growth expectations in 2021 and beyond.
Reflecting this optimism, U.S. stocks, as measured by the S&P 500 Index, increased 6.2%, hitting another all-time high just before quarter end. All market sectors posted gains, although those sectors benefiting from higher interest rates and the cyclical recovery easily led the pack. Energy posted a second consecutive quarter at the top, gaining 31%. Financials, Industrials, Materials, and Real Estate posted respectable high single-digit to low double-digit returns. As investors rotated toward these beneficiaries of the recovery, the more defensive sectors and those seen as having higher organic growth became a source of funds, with Consumer Staples, Information Technology, Utilities, Consumer Discretionary, and Health Care posting more modest low single-digit gains.
Small cap stocks, as measured by the Russell 2000 Index, viewed as the clear winners in an economic recovery, gained 12.7%. In addition to the same leadership sectors as large caps, small cap Consumer Discretionary and Consumer Staples names also performed quite strongly, as the composition of these sectors in the small cap universe is heavily skewed toward recovery names in retail, restaurants and leisure industries. Lagging sectors also mimicked those in large cap, with Health Care hit particularly hard by weakness in Biotech, one of very few industries to show a decline in the quarter.
On top of substantial relative performance gains last quarter, small caps continued to hold their advantage over large caps, outperforming by 6.5%. Economic recovery plays are particularly overrepresented in Value sectors, thus Value outperformed Growth in the quarter; by over 10% in large caps and over 16% in small caps.
The positive scenario for economic growth has been well discussed and outlined above: stimulus plus reopening equals a strong recovery. Key surveys including ISM Manufacturing, ISM Services and Consumer Confidence are all at strong levels, signaling growth. The March employment report showed a solid increase in jobs, while the unemployment rate fell to just over 6%. GDP growth in the mid-high single digits is at levels not seen in well over a decade. Housing demand remains robust, and prices continue moving up. And all of this is before we have seen the full impact of the latest pandemic relief programs or the full reopening of the economy, not to mention the $2 trillion infrastructure bill being discussed in Washington.
So it is abundantly clear what will go right with this economy, but as good analysts we must ask ourselves what can go wrong. In the short term, supply chain issues have caused shortages and higher prices on everything from skilled labor to commodities to finished goods to distribution. But as supply chains are reestablished over the course of the next year, we will be back to a world of adequate global supply. There is no doubt an inflation scare or two are likely, but for the longer term we remain sanguine. We do not expect a return to a world of zero inflation, but a manageable range of 2–3%, as the Fed has promised, is likely.
Despite the continued upward movement in the stock market, valuation levels have actually declined modestly as earnings expectations have risen more than stock prices. This is not an uncommon development at this stage of an economic recovery.
As the pandemic slowly fades and the world returns to more solid footing, pent-up demand should drive strong results in the consumer economy, while resolving supply chain issues and restocking inventories should drive the industrial economy. In this environment, we continue to move toward more economically-sensitive names and those likely to benefit from the post-pandemic recovery. We feel confident we can do such without moving away from our conviction in owning well-managed companies with strong market positions and strong financial characteristics.