March was a strong month for most stock asset classes but provided more frustration for bond investors. The S&P 500 gained 4.38% while U.S. mid- and small-cap stocks gained 4.63% and 3.33%, respectively. International returns were mixed, with the developed market index MSCI EAFE positive by 2.30% and the emerging market index MSCI EM negative at -1.51%. Meanwhile, the most commonly referenced bond index, the Bloomberg Barclays US Aggregate, saw its third consecutive month of declines with a -1.25% loss. This completes a quarter in which the “Agg” lost -3.37%. In Bond World that is nothing to sneeze at; in fact, -3.37% is the worst quarterly decline for the Agg since it saw a -4.06% decline in Q3 1981 and it is the fourth worst quarterly return the index has experienced since it was created in 1976. If you’ve been reading this newsletter over the past few months, you can probably guess what has caused further bond declines: rising interest rates. With an inverse relationship between bond prices and interest rate movements, it didn’t help that the yield on the 10 Year Treasury rose from 1.45% at the beginning of March to 1.73% by the end, rising as high as 1.77% on March 30th.

Much of March was a continuation of trends covered in last month's Investor Insights. Inflation expectations are what is driving interest rates higher; the impact of rising rates on stock market leadership rotating from growth, particularly technology companies, to value, particularly financials. There have been some additional developments worth mentioning, too. In March the leading sector in the S&P 500 was Utilities, which gained 10.51%. This strikes market observers as somewhat counterintuitive in a rising interest rate environment, as the Utilities sector is typically most attractive when bond interest rates are lower because of the comparatively high yield offered by utility stocks. Industrials and Materials also saw strong returns in March, likely due to the increasing talk of an infrastructure bill coming out of Washington. The performance of Utilities, Industrials and Materials adds volume to the drum that we love to beat in this newsletter: the importance of diversification in your portfolio. If you think you own these sectors in your S&P 500 ETF, well you do, but the combined weight of all three in the index is less than 14%. Meanwhile, the hottest sectors of 2020, Information Technology and Consumer Cyclicals, combine for over 36% of the index (Info Tech is nearly 24% alone), and both are lagging this year. While we aren’t advocating for the equal weighting of sectors in your portfolio, we do think it’s critical to maintain exposure to a wide variety of sectors and asset classes, including those that may have underperformed recently.

Financials also had a strong month due to the increase in interest rates and the Fed’s announcement that pandemic-related restrictions on Bank dividends and stock buybacks would be lifted on June 1; the sector finished with a 5.80% return. However, the news that a family office, Archegos Capital, had unwound approximately $30 billion in investments gone sour put pressure on the banking sector in general. More specifically on the banks Nomura and Credit Suisse, which warned investors of “significant losses” related to their margin lending relationship with Archegos.

Looking ahead, much of the first quarter’s areas of focus will remain on the table. One addition, we believe, will be an increased amount of chatter around changes to existing tax law from the Biden administration. On March 31st the president outlined an array of proposals. Investors should recognize this initial talk as the starting point of negotiations in Congress and not any sort of final deal. That said, a few of the highlights in Biden’s plan include increasing the corporate tax rate from 21% to 28%, increasing income taxes on families that make over $400,000 per year, a financial transactions tax, and taxing capital gains as regular income for wealthy people regardless of whether those gains are short or long term. Setting aside the policy merits of Biden’s tax proposals, most pundits do not seem particularly worried about the near-term impact of such policies on the markets. Their argument is supported by the fact of strong investor returns before Trump’s Tax Cuts and Jobs Act of 2017, as before the TCJA both corporate and individual income taxes were higher than Biden’s proposals go for and the markets saw strong returns. We feel it is too early to assess the impact of a new tax law on the markets because no one knows what the final product, if there even is one, will look like. That said, investors shouldn’t be surprised if markets react either positively or negatively to the shifting winds of this topic as lawmakers in Washington engage in what will probably be a months-long negotiation period.

The first quarter of 2021 has reinforced a couple of investing principles that can be easy to lose sight of in the noise of financial media and our short attention spans. The first, exemplified by the massive rotation from growth to value and from large-cap to small-cap, is that investors should diversify across many types of stocks and bonds in their portfolio and avoid chasing the returns of whatever has worked well recently. Rotations like we’ve seen are impossible to predict, especially in a consistent manner over the long run. The second lesson is that even highly risk averse investors should evaluate whether to add some stocks to their portfolios. While it may be counterintuitive, you can potentially reduce a 100% bond portfolio’s risk by adding a small amount of carefully selected stock exposure. This is because stocks and bonds typically have a low correlation, and in periods like the first quarter of 2021, your stock gains would have potentially offset some of your bond losses. Let us add a third piece of wisdom that may be tough to remember in this particular market environment: don’t get rid of your bonds just because they’re going through a rough patch. If you are concerned about the potential for interest rates to go even higher from here and the impact on your bonds, work with your financial advisor to take steps to insulate your bonds, for example by limiting duration. Bonds are in your portfolio to reduce risk and provide income. They serve as a loss mitigator when stocks are in selloff mode. And, the higher rates go, the better forward-looking prospects for bonds become. The cardinal rule of investing—buy low and sell high—applies to both stocks and bonds.

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