"In our view, monetary and fiscal stimulus will gradually support a return to endogenous, positive, nominal economic growth."
Jennison Associates LLC
Market in Review
Equity markets extended their gains in the first quarter of 2021 but were volatile amid a backdrop of U.S. political turmoil and continued COVID-19 uncertainty. In January, Democratic wins in Georgia's Senate runoff elections sealed a Democratic majority in Congress. This was followed by an extraordinary breach of the U.S. Capitol. As the month drew to a close, President Joseph Biden and Vice President Kamala Harris were inaugurated.
Although overall COVID-19 trends improved, steps to reopen certain U.S. states were met with rising case counts and mortality rates. Similar and, at times, worse scenarios unfolded across the globe, with a number of European nations forced back into full or partial lockdowns. Encouragingly, however, the pace of vaccinations in the United States improved as the quarter progressed and a new vaccine from Johnson & Johnson was introduced in February.
The new U.S. administration moved quickly to pass the American Rescue Plan Act and, in March, finalized a $1.9 trillion package consisting of direct payments to individuals and families, additional unemployment benefits, funding for state and local governments, and funds for vaccinations and testing.
Cyclical stocks performed well during the quarter as investors favored companies hit worst by the pandemic, amid rising expectations that the U.S. economy will reopen this year. Small-cap companies were notable outperformers due to their greater exposure to U.S. economic activity compared to large multinational firms.
The Federal Reserve continued to advocate for extreme policy accommodation, citing the pandemic's drag on the labor market. Longer term bond yields rose, reflecting U.S. monetary and fiscal stimulus, and rising inflation expectations. The 10-year U.S. Treasury yield ended the quarter at 1.74%, compared to 0.92% at the beginning of the year.
Portfolio Performance
The Harbor Capital Appreciation Fund (Institutional Class, "Fund") returned -3.39% during the first quarter of 2021, underperforming its benchmarks, the Russell 1000® Growth Index, which returned 0.94%, and the S&P 500 Index, which returned 6.17%. Among the benchmarks' larger sectors, Communication Services, Health Care, and Industrials outperformed and were the biggest contributors to performance. Meanwhile, the Information Technology and Consumer Discretionary sectors retreated and weighed most on the indexes.
The Fund underperformed the index over the quarter. Information Technology, Consumer Discretionary, and Health Care sector holdings detracted from absolute and relative returns. Positions in Communication Services helped in absolute terms but detracted from relative performance. Consumer Staples holdings contributed positively in both absolute and relative terms.
Contributors & Detractors
Digitalization trends remained strong and continued to be accentuated by the remote work environment. A number of companies reported strong earnings and revenue growth during the quarter, helped by continued demand for digital advertising. These included Alphabet (GOOG, Financial)(GOOGL, Financial) and Facebook (FB, Financial). Market demand for services provided by these companies continues to grow, with Alphabet's results driven by double-digit increases in search revenue and acceleration in YouTube's revenue growth.
Several technology-related companies gave back some of their impressive gains, following a rapid increase in their valuations last year. Importantly, they continued to deliver strong earnings during the quarter. Investors have begun to anticipate more difficult year-over-year comparisons, given an outstanding 2020 for these companies. Apple (AAPL, Financial) and Amazon (AMZN, Financial) are two examples. We believe that their long-term fundamentals remain strong, and that it is important to look beyond short-term price movements.
Buys & Sells
During the quarter we purchased Snap (SNAP, Financial), a camera and social media company, which develops and maintains technological products and services, including Snapchat, Spectacles, and Bitmoji. The company has several technological innovations and product partnerships that, along with what we consider a favorable macro backdrop for online advertising, bode well for revenue growth acceleration. Accelerating user growth, particularly internationally, and an improved ad platform are additional tailwinds. The company reported stronger-than-anticipated earnings in the fourth quarter of 2020 and provided guidance for solid revenue growth over the next several years.
We also added Eli Lilly (LLY, Financial) to the Fund. Eli Lilly's core focus has historically included diabetes and central nervous system (CNS) and psychiatric treatments. In recent years, the company has diversified its business, adding immunology and oncology products. Margin expansion, driven by product mix shifts and management's commitment to improving the margin profile, is a key element of our investment thesis. We expect stability in Lilly's diabetes franchise despite new entrants to the market, and we believe the long-term potential for Jardiance, another Lilly diabetes product, is underestimated. In Lilly's immunology franchise, we expect strong sales growth over the next several years. We believe that recent oncology acquisitions will continue to bear fruit, and that the company's early-stage pipeline, particularly in oncology, is underestimated. We also find early-stage clinical trial data for the company's Alzheimer's disease therapy encouraging.
Although Vertex Pharmaceuticals (VRTX, Financial) performed well in the first three quarters of 2020, we exited the position, as management's fourth quarter guidance relating to lower royalties on new products was disappointing. Guidance on sales growth in early 2021 was also a concern.
Splunk (SPLK, Financial) makes software that allows businesses to mine and analyze burgeoning amounts of digital data. We eliminated the position due to disappointing fourth quarter sales revenue, which also failed to make up for ground lost in the third quarter, due to longer decision-making cycles in a pandemic environment. Additionally, we see more competitive pressures forming for the company.
Outlook
Just twelve months ago, the outlook was bleak, as the world was in the early grip of the pandemic with no vaccine in sight. By contrast, there are now three approved vaccines in the United States, with a host of other vaccines available internationally. As economies around the world reopen, and markets rally, fear has given way to optimism and confidence in the strength of the coming global recovery.
The demand recovery is creating global bottlenecks and supply constraints. Strong U.S. housing demand has driven up house prices and transaction rates. While mortgages remain affordable, interest rates have begun to rise, which has added to the uncertainty and weighs on equity valuations. We believe inflationary fears will prove transitory. The recovery should normalize once economies worldwide reopen in a sustainable manner, and as the effects of fiscal and monetary stimulus fade. We believe rising bond yields reflect expectations of more normal levels of future growth.
Late last year, investors began to favor areas of the market most exposed to a recovery and most debilitated by the pandemic. This rotation boosted valuations of economically sensitive companies and reduced the earnings multiples of secular growth companies. History shows us that these corrections are not unusual and have been temporary.
While the first quarter was challenging from that standpoint, we are encouraged by the continued strong results of the companies in the Fund and the positive expectations for the remainder of 2021 and beyond. Secular growth opportunities remain the focus of the Fund as they have been over Jennison's long history of growth investing.
We believe that the moderation in valuations over the quarter improves the outlook for share price appreciation, adding to the attractiveness of the superior growth characteristics that we seek over an extended investment time horizon.
Performance data shown represents past performance and is no guarantee of future results. Past performance is net of management fees and expenses and reflects reinvested dividends and distributions. Past performance reflects the beneficial effect of any expense waivers or reimbursements, without which returns would have been lower. Investment returns and principal value will fluctuate and when redeemed may be worth more or less than their original cost. Returns for periods less than one year are not annualized. Current performance may be higher or lower and is available through the most recent month end at harborfunds.com or by calling 800-422-1050.
Views expressed herein are drawn from commentary provided to Harbor by the subadvisor and may not be reflective of their current opinions or future actions, are subject to change without prior notice, and should not be considered investment advice.
This information should not be considered as a recommendation to purchase or sell a particular security. The weightings, holdings, industries, sectors, countries, and returns mentioned may change at any time and may not represent current or future investments.
