The Inflation Surprise - Holdun



  • Global Equities advanced in Q1 despite some short-term volatility as the vaccine rollout, and robust U.S. stimulus boosted sentiment
  • Government Bond Yields jumped amid inflation fears, pushing bond prices lower
  • Biden takes office and goes big on stimulus, spurring both growth hopes and inflation fears


If you’re new to investing, you could be forgiven for thinking that all stocks do is go up and up. Since the pandemic hit last March, markets have recorded the fastest comeback in history and seem to be hitting new record highs almost daily. An even more impressive turnaround given the apocalyptic economic backdrop. Over the 1-year period, the S&P 500 has rallied over 80% from around 2,200 on March 23, 2020, to just shy of the 4,000 level by the end of Q1 2021.

In our 2021 outlook report, we outlined how volatility will inevitably become a more precarious and consistent factor for investors. In February, we saw this storyline play out for the first time. Equity markets started the quarter strongly, but February was littered with bouts of volatility as inflation fears pushed long-term government interest rates higher, weighing on many of the story stocks and the global bond market as a whole.

Ultimately, progress on Covid, massive amounts of monetary and fiscal stimulus, and optimism on vaccines and the reopening of the economy prevailed, pushing equity markets higher in the process.



The Biden administration has clearly indicated its intention to continue the huge fiscal spending into 2021 through a ‘once in a generation’ infrastructure plan. Congress passed the American Rescue Plan worth about $1.9 trillion in March 2021, with President Biden also promising an additional $2 trillion in infrastructure spending.

This was the third major stimulus package passed in the last year following the $2 trillion CARES Act in March 2020 and the $900 billion Covid-19 Aid bill in December 2020.

Public Debt at Its Highest Since 1946

Source: CBO

Inflation Fears

Following almost a decade of dormant inflation figures, Inflation data has reclaimed a level of notoriety in 2021, becoming the most closely watch market metric in recent months as investors look to determine future interest rate movements.

The first true glimpse of the much-touted inflation return materialized over Q1. March CPI (Consumer Price Index) figures, a popular inflation metric, jumped by the highest amount in nearly nine years, while surveys of manufacturing purchasing managers and small businesses reveal the highest price increases and inflationary pressures in more than a decade.

We believe the inflation readings will pick up in the next few months but perhaps not at the uncontrollable rate that some seem to be predicting. Secular forces, including persistent pandemic issues, demographics, and technological innovation, will partially offset the Goldilocks’s environment that the fiscal and monetary support has created.

Economic Growth

Besides inflation, the other major factor influencing interest rate movements is expected economic growth. After declining by 3.5% in 2020, Real GDP is expected to increase by +6.5% in 2021 and +3.3% in 2022. This combination of higher inflation and positive economic growth is expected to push long-term bond yields higher and steepen the yield curve as the Fed continues to anchor the short-term fed funds rate.


US equities posted strong Q1 returns. The S&P 500 increased by +6.2% in the first quarter, reaching another all-time high on March 26th.

The Upward Trend Continues

Source: Yahoo Finance

The market rotation that started late in 2020 also continued, with small- and mid-caps outperforming large-caps, while value stocks easily outpaced growth stocks.

Sector returns varied widely. Energy shares within the S&P 500 Index recorded a total return of nearly 31% as oil prices hit their highest levels in almost two years. Conversely, consumer staples and information technology shares returned under 2%.

The Rotation Trade

The most recent rise in yields resulted in a further rotation out of some of last year’s biggest winners into value and cyclical stocks. While this is potentially just a short-term shift, it has helped reverse some of the growth outperformance the has haunted value investors in recent years.

Value Stocks Narrow the Gap

Source: Financial Times


While it’s easy to over-analyze the specific variables at play during this latest rotation, the reality is, many investors were simply waiting for any excuse to push the giant red button, ejecting them out of some of the stay-at-home winners and into stocks that arguably have more room to run from a valuation standpoint. For Tech stocks that have seen mammoth growth in recent times, the endless upward trajectory was unsustainable at current rates and inflation fears just applied the brakes to allow for a cooling-off period.

The increase in interest rates has taken some of the air out of the most speculative areas of the stock market. Companies with a great story but no foreseeable earnings in the near term hold a more compelling narrative in environments where money is cheap but less so when interest rates move higher. Higher interest rates will also increase debt repayment at a time when corporate debt is at all-time highs, weighing on the margins of many of these growth names. Dividend stocks could also experience some substitution effect as interest rates run higher. Investors may be looking to take some risk off the table and move into fixed income as the dividend earning yield narrows relative to bond yields.

In our view, these rotations are a part of the normal market function and a positive development for the overall health of the market.

Despite the recent run, the rotation into value still has room to run with sectors such as financials, industrials and energy likely benefit as economic metrics continue to pick up.

Bond Yields

As mentioned, long-term Government bond yield movements dominated financial news this quarter. The 10-year US Treasury yield rose from 0.91% to 1.74%, its highest level since early 2020. It was the second-worst quarter since 1980 for US Treasuries prices (Bond prices and yields move in opposite directions.)

Again, as inflation and economic growth picks up, the base case scenario will see bond yields tick slowly higher, creating duration issues for those holding traditional long-term government bonds, essentially creating a ‘return-free risk’ environment.

US 10 Year Treasury Rebound


Source: Financial Times



The commodity bull market is in full swing, given the supply/demand restraints that the pandemic has created. Challenging logistics in a covid environment has led to supply shortages. This, combined with rising inflation fears, has seen prices of base metals and oil jump over Q1, with copper up over 20% for the quarter; a trend that could well continue.


2021 has so far been a huge year for the cryptocurrency market as a whole, with the total crypto market capitalization jumping 130% since the start of the year.

Inflated equities markets and institutional adoption has made the world of digital currencies all the more appealing to both retail and institutional investors.

Bitcoin continued its upward march. Follow its most successful Q1 in eight years, the Crypto hit a record close just shy of $62,000.

While there is undoubtedly considerable volatility ahead, the ever-increasing institutional adaption will accelerate the move from a speculative asset, to a noteworthy financial asset class of choice for a broad spectrum of investors into the future.


For Q4 2020, nearly 80% of S&P 500 companies reported EPS above estimates. This was the third-highest % of S&P 500 companies reporting a positive EPS surprise since 2008.

Looking forward to Q1 2020, earnings for companies in the S&P 500 are forecast to jump more than 24%, with the consumer discretionary and financials sectors expected to see the biggest gains as these ‘recovery areas’ benefit from the economic re-opening.

While a 24% jump in earnings may seem substantial, this is a year-over-year comparison, and you may recall that Q1 2020 was a less than ideal time for corporate earnings…. Or anyone for that matter.

After 2020’s steep decline in corporate earnings, a strong recovery is needed to provide fundamental support for additional gains. Any companies falling below expectation are likely to be dually punished.

Story of the Quarter

After a few years of writing and talking about financial markets, you start to realise that most of what you speak about causes involuntary narcolepsy in roughly 90% of people. Ramblings about central bank policies and economic indicators aren’t exactly edge of your seat stuff for most sane individuals.

However, every now and then, a crazy event happens that perks the interest of even the most avid market skeptic. In January of Q1, one such event occurred. Finances answer to David vs Goliath, if you will. David, in this case, took the form of Reddit retail traders, who banded together to punish Wall Street speculators for betting against GameStop, a previously unloved video game retailer. GameStop shares surged from $19 at the start of the year to as much as $483 in the process, eventually finishing out the quarter at $185.


Source: Yun Li and Maggie Fitzgerald, ‘Dow drops more than 600 points Friday, suffers worst week since October amid GameStop trading frenzy’ (CNBC, 28 January 2021) <> accessed 26 April 2021

Sector Breakdown

All eleven sectors were positive for the quarter, with Energy, financials and industrials leading the way. Technology and consumer staples lagged.

S&P 500 Performance by Sector – Q1 2021

Asset Class Performance

Crude oil, US small-cap, REITs, and Commodities led the way during Q1. Rising bond yields caused fixed income returns to struggle.

Value (Russell 1000 Value: +11.2%) outperformed Growth (Russell 1000 Growth: +0.9%) for the 2nd consecutive quarter.

YTD Asset Class Performance to End March 2021



The main pillars that drove markets to all-time highs throughout 2020 are still in place. Since then, markets have been boosted by further US fiscal stimulus, strong fourth-quarter earnings and upgrades to global growth forecasts, supported by the vaccine rollout.

However, this year the stock market will face headwinds caused by the economic recovery, including higher interest rates, the possibility that the Fed may tighten earlier than expected, and the potential for higher taxes.

Inflation will continue to be the focal point that dictates market movements from here, with volatile growth-based story stocks and some dividend names the most obvious causalities if a persistent inflation increase pushes yields higher over the medium term.

Cyclical value looks likely to continue to outperform. The financial sector will reap the benefit of a steeper yield curve, creating a wider net interest margin for Banks. Energy and commodities will likely benefit from supply-side contraction and an uptick in inflation, while consumer discretionary should benefit from an inflationary boom cycle as the economy reopens and pent-up demand re-enters the market.

In short, while equity markets are expensive in absolute terms, they remain attractive in relative terms, given the TINA (there is no alternative) environment that has been created as a result of ultra-supportive monetary policy, suppressing opportunities with the fixed income market.

The unfortunate news for investors; ‘finger in the air’ stock picking may not be as bulletproof an investment plan from here on in. While opportunities still exist, investors will need to dive into fundamentals and become pickier in their selection process going forward.