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Stocks rebound from COVID-19 crater to new highs as inflation, bond risks near

U.S. stock markets reached dizzying highs in the first quarter of 2021 in stark contrast to the same period in 2020 when the COVID-19 pandemic pushed equities to gut-wrenching lows.

"Within about a one-week window in March [2020], traders collectively realized that we would have a deep recession through the middle of the year at least, but once we reached the summer and the infection numbers improved, traders then rushed back the other way to bet on a coordinated 'reopening trade,'" said Matthew Weller, global head of research at GAIN Capital, in an interview.

That reopening trade came into full view in the first quarter of 2021, which served as a counterweight to the first quarter of 2020 when lockdown measures were put into place and equities quickly dipped. Those two quarters, one year apart, offer a view of the stock market headed into a global pandemic and one, potentially, headed out.

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Equity analysts believe that much of the expected economic recovery has already been factored in and see a few potential headwinds for stocks, including challenges from the ongoing global response to COVID-19 and monetary policy.

"I think equities have surged enough for now," said Edward Moya, a senior market analyst with OANDA. "A lot of the good news has already been priced in and it would be healthy for stocks to consolidate."

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All major U.S. stock indexes set new record highs in the first quarter of the year.

Since the start of 2021, as investors anxiously edged towards a lessening of social distancing restrictions and the economic recovery expected to follow, the S&P 500 has seen 15 separate record high settlements.

Overall, the S&P gained 5.77% in the first quarter of 2021, compared to a decline of 20% in the first quarter of 2020.

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"The pace of the stock market recovery has been unbelievable," said Moya.

Sectors have also rebounded strongly, none more than the energy sector, which fell by over 51% in the first quarter of 2020 but climbed by over 36% in the first quarter of 2021. That was largely due to an increase in oil prices and expectations of a return to normalcy this year for petroleum demand.

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No company saw its share price whipsaw more during these two quarters than Marathon Oil Corp., which fell by 75.8% in the first quarter of 2020, one of the worst performances of any S&P 500 company, and then climbed by 60.1% in the first quarter of 2021. Only L Brands had a better first quarter this year on the S&P 500 than Marathon.

Moya said the ongoing bull market has been bolstered by a confluence of events, including Democrats taking control of the U.S. Senate and ushering a new round of stimulus spending, a surprisingly rapid development of effective COVID-19 vaccines and expectations that U.S. growth will outpace Europe and emerging markets now bracing for the third wave of infections.

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These bullish factors supported the rebound of stock prices within many of the S&P 500 industries hardest hit by the pandemic, including hotels, resorts and cruise lines, which fell by nearly 59% in the first quarter of 2020 and climbed over 16% in the first quarter of 2021. Also rebounding are airlines, which plummeted nearly 51% and then jumped 32% during those same quarters.

The bounce in stock prices of these pandemic-battered industries may have already leveled off, said John Davi, founder and chief investment officer of Astoria Portfolio Advisors.

"I think that the easy money has been made," Davi said in an interview. "We're now going to transition to the next phase of the cycle … and stocks have a couple of headwinds."

A setback in the pace of vaccinations, new COVID-19 strains and additional lockdown measures are some of the risks facing equity markets, experts say.

Rising bond yields, which have hit levels not seen since January, may weigh on stock performance, and an increase in corporate taxes, pitched by President Joe Biden to fund his mammoth infrastructure and energy plan, could soon negatively impact earnings.

Analysts said inflation fears may be a major drag on stock performance as well.

The Federal Reserve changed its monetary framework in August 2020 to let inflation climb above 2% for some time in order to compensate for the time spent below that target. This could present risks for markets if inflation expectations become unanchored from reality, said Michael Crook, deputy chief investment officer at Mill Creek Capital Advisors.

"There are no good outcomes if inflation expectations become unanchored," Crook said in an interview. "We're in uncharted territory on a lot of fronts."

The Fed plans to keep its benchmark rate at effectively 0% until it sees a "broad-based and inclusive" job market recovery, along with inflation reaching 2% and being on track to moderately overshoot it.

The price index for core personal consumption expenditures, which strips out food and energy prices and is the Fed's preferred inflation measure, rose by 1.4% year over year in February. The five-year breakeven inflation rate, a rough measure of the bond market's view of inflation over the next five years, closed on March 31 at 2.54%.

The Fed has also indicated it will keep buying $120 billion in bonds each month until it sees "substantial further progress" on those goals.

Fed policy, which helped pull equities from their early pandemic depths, has also clouded much of the potential downside the market now faces, said Peter Cecchini, CEO and founder of AlphaOmega Advisors.

"Certainly, the reopening is key, but the enormity of the fiscal response is equally important," Cecchini said. "It's inorganic and temporary."

Cecchini said investors appear to be overestimating the strength of the economy and earnings once the major impacts of the pandemic largely subside.

"They seem to be assuming that earnings growth will somehow continue to rebound as if it were growing like wildfire before the pandemic, which was not the case," he said.