2021 Investment Outlook
Financial markets contributed their own chapter to the extraordinary story of 2020, engineering a remarkable turnaround and putting a close to the fastest bear market in history. Although scientists and health experts expect COVID-19 to wind down in 2021, last year’s events in the global economy and markets will likely persist throughout this year and well beyond. We expect that part of the story remains far from over, with much yet to be told.
After a placid start to 2020, markets began to react violently to the shock and growing uncertainty of COVID-19 effects in late February. On March 11, the U.S. bull market of almost exactly 11 years ended with the Dow Jones Industrial Average and S&P 500 Index both slipping 20% from their all-time highs. A mere twelve days later, markets bottomed and began an almost relentless rally that would continue through year-end and into the early days of 2021. As of this report, the S&P 500 has rallied over 70% from its March 23, 2020 low.
There are many technical and specific questions that could be asked about last year’s events and our projections for 2021. They might be best summarized with this singular question/reaction: “WHAT’S WITH THIS MARKET?” (cue incredulous look or head shake). It has become a common refrain from clients, and we are even guilty of similar outbursts from time to time in staff meetings and email/text message chains.
Like almost any stock market question, the answer is…complicated. We certainly did not have the crystal ball to foresee 2020’s roller coaster ride, but we can use history as a tool to explain the journey and provide some insight into the future.
The primary and most obvious explanation in the market’s stabilization and recovery was the Federal Reserve. This was accomplished first in the immediate reduction of the Federal funds rate to zero in mid-March, and second in the form of monetary stimulus. By the end of 2020, the Fed had increased its balance sheet by over $3 trillion, injecting massive liquidity into the financial system, setting the risk-free interest rate at zero indefinitely and encouraging investment (and some would argue, speculation).
As markets fell and stabilized, it was apparent there were distinct winners and losers; companies directly affected by the pandemic were severely punished while others that could withstand or even thrive in 2020’s environment were rewarded. These areas were identified by their classic style designations of “growth” vs. “value” stocks, or “stay at home” vs. “reopening” stocks, or other thematic investing phrases. Growth stocks, which have long led the market and historically were expensive at the beginning of the pandemic, led the way until the final months of the year.
Throughout the summer, despite the devastating 1/3 decline of U.S. Gross Domestic Product (GDP) in the second quarter, markets calibrated that the worst-case scenarios were off the table (at least for Wall Street). Earnings expectations, slashed by analysts, began to moderate, and even though nominal levels were down significantly from 2019, there was optimism for 2021 and the prospect of vaccines and continued stimulus. Toward the end of the year, earnings estimates continued to rise while corporate results were better than feared. Third quarter GDP bounced back to be 33.4% higher.
We recap these events to contrast them against some more sobering analysis and to remind you of our opening comment; the story, while improving, is far from over.
The Federal Reserve’s commitment to zero interest rates through 2023 is reminiscent of similar policies during much of the 2009-2020 bull market. Low, especially near zero interest rates tend to justify higher valuations on stocks. This became particularly apparent in the growth sectors of the market, where expensive valuations morphed into extremely rich or even absurd last year depending on which company was being measured. In 2020, the Fed became even more adamant about their commitment to low interest rates. In years past, they used an inflation target of 2% as a standard for interest rate neutrality. Following the pandemic, their stance changed; they will not likely raise rates until they see an inflation level around a 2% average. Not believing low rates is enough, the Fed is now signaling to the market they desire higher inflation. It might be suggested their attitude has changed from someone concerned about fire hazards, to that same individual bringing out flint and steel to start a fire, with the belief it can be contained if it gets too severe.
This “hazard” is one of the primary risks we see to our market forecast in 2021. While we are now in a bull market, this one does not share many similarities to the one that began in 2009 and was extinguished last year. In March 2009, market valuations were significantly cheaper than in March 2020, particularly in U.S. large cap equities. That market saw a long, slow recovery from a lengthy recession; this market saw a rapid snapback in stock prices and economic activity. That market also had easy monetary policy (low interest rates), but also nowhere near the level of fiscal stimulus and government support that has accompanied the pandemic economy. In fact, we continue to grow optimistic about the level of economic growth in 2021. We are already starting to see green shoots of inflation in the economy, something that was not an issue coming out of the Great Recession. With the prospect of the Biden administration and Democratic led Congress enacting additional stimulus and fiscal spending, we see higher inflation and interest rates as a risk to stocks in 2021. The market reaction to the November election appeared to signal the market is more confident in broad stimulus that will benefit smaller companies and businesses. Last year, it was clear the economy and stock market decoupled. This year could result in a similar, but reversed outcome; a thriving economy but jittery stock market concerned about looming inflation and changes in Fed policy. Longer term, it remains to be seen if the economy can maintain momentum without supportive policy measures. Even more concerning is the prospect of the Fed continuing to act and the economy too fatigued to respond. That may be a story for 2022 or 2023, but markets as always will be ahead of the curve, meaning it still could impact investors sooner rather than later.
Equity Tactical Allocations
We have a neutral position in equities relative to clients’ investment objectives and allocations to other asset classes. Our positive factors for stocks include the early stage of economic recovery, the current broad-based price momentum across most sectors and styles, and continued Federal Reserve support from monetary stimulus and low interest rates. Our negative factors for stocks are very expensive valuations in many sectors and increasingly bullish sentiment. We subscribe to Warren Buffett’s maxim of “be fearful when others are greedy and greedy when others are fearful”.
We currently have a neutral to slight value style bias in our stock selection. We believe the value style is in a very favorable position to outperform growth over the next several years. There are historically wide valuation spreads between growth and value stocks. Value stocks should benefit from current economic conditions, while growth stock valuations may deteriorate in an inflationary, higher interest rate environment. However, growth stocks continue to have very solid earnings trends and many of those companies benefit from the pandemic influenced economy. We would likely reduce our exposure to growth stocks if those trends deteriorated, or if increases in interest rates and/or inflation caused them to lose momentum and performance leadership in the market.
We are tactically increasing our allocation to small and mid cap stocks versus large cap. Much like value stocks, small caps have been out of favor and underperformed large caps for several years. Small caps had an extraordinary fourth quarter, with the Russell 2000 Index rallying 31.4%! We believe small and mid cap stocks, particularly with a value focus, appear attractive in a market full of expensive sectors.
We are neutrally positioned in international stocks and overweight to emerging markets. The U.S. dollar weakened throughout the second half of 2020 as the global economy began to stabilize from COVID-19 and the U.S. government signaled continued deficit financing and monetary stimulus programs. We think the dollar, which has generally remained firm over the prior six years, will continue to be under pressure from the inflationary forces that will likely continue in 2021. This should benefit international markets and particularly emerging market economies. Both developed and emerging market stocks have more attractive valuations than the U.S. Their economic recoveries and growth trends appear favorable. U.S. and international market leadership tends to be cyclical; following a stretched period of U.S. outperformance in the 2010’s, we believe international markets are positioned to perform favorably in the coming decade. We see a number of similarities to the 2000-2007 period following the tech bubble, when international stocks had an extended period of outperformance.
Fixed Income Tactical Allocations
We are slightly underweight duration in our bond portfolios. Given our earlier commentary on inflationary pressures and continued deficit spending, our expectation is for a steepening yield curve and higher long term interest rates in 2021.
We are overweight corporate bonds and underweight Treasuries in our taxable bond portfolios. The favorable economic backdrop creates an environment that should benefit corporate debt, and Treasury yields provide little upside. If our outlook on equity markets turns more sour, we may reduce our exposure to corporate bonds; their yield spreads over Treasuries have narrowed significantly in recent months.
We are neutral on municipal bonds due to similar tightening spreads versus Treasuries. The expectation of higher taxes and the Federal Reserve backdrop have been supportive of municipal bond credits, and we will watch carefully to see how tax policy changes might affect this market. Like corporates, we will seek to identify any chinks in the armor with very narrow credit spreads and little margin for error on municipal balance sheet recovery.
We are using high yield and emerging market bonds as opportunistic fixed income allocations to increase yield and provide diversification benefits. We are using local currency exposure in our international bond allocation to provide hedging benefits against a weaker dollar.
Alternative Investment Update
A rise in inflationary expectations could finally lift commodities prices, which have largely been dormant over the last decade. For clients with more defensive portfolios or a total return rather than income focus, we have selectively allocated to managed futures strategies as an indirect investment in commodities. Managed futures benefit from price trends in commodities (both up and down), as well as sharp movements in currencies, interest rates and equities. The Federal Reserve has assisted in dampening volatility since March, but any change in policy or market sentiment could reignite old trends or exacerbate new ones. Managed futures have had success in past market cycles protecting or even growing capital during negative periods for stock returns.
We selectively use long-short and multi-strategy hedge funds to reduce portfolio volatility or take advantage of a market niche we find opportunistic. We also believe private equity and debt strategies represent drivers of long term returns in a market where public equity returns will likely be modest in the coming decade. We utilized one such manager last year and are evaluating several others that have fund openings later this year.
On a societal note, the past year has been challenging for all of us, and stress about finances and markets only add to the difficulties we face. We do not take lightly the responsibility you have entrusted us with to manage your family’s wealth.
We see a balanced mix of challenges and opportunities in markets, and are closely monitoring trends that may adjust our outlook. We expect the easy journey investors traveled through the 2009-2020 bull market is over. Instead, we see many parallels with the 1999-2009 cycle, which saw two very deep bear markets for the U.S. and the infamous “lost decade” for the S&P 500 Index.
We believe creative asset allocation will be essential to investment success in the 2020’s. The buy and hold philosophy of equity index funds will almost certainly fail to live up to the last ten years. A key question will be what index or factor (i.e. large vs. small, growth vs. value, U.S. vs. foreign) to buy. Another question we frequently ask is, are there better alternatives to the index? Because of the dominance of technology and growth stocks the last several years, the U.S. market has inherently become a “growth” index despite holding a diverse set of companies across sectors. The top of the index has become dominated by well-known brands, a few even reasonably priced, while many others seem to be poster children for excess and speculation (we’re looking at you, Tesla).
Likewise, fixed income has become a challenged asset class with the Fed’s zero interest rate policy and creeping inflation. It has sparked a number of theories and acronyms to explain the recent stock rally (TINA = there is no alternative (to stocks), FOMO = fear of missing out). We are not ready to throw in the towel on bonds, but at current yields, see them more as dry powder to buy future undervalued equities rather than a cash register to accrue 1% annual coupons the next 5-10 years. We would tell the TINA crowd that bond yields are paltry, but bonds are unlikely to lose 20, 30, or 40% of their value in a short period of time. At current valuations, it would be no great leap to see stocks drop these levels before you could say “bear market”.
Thank you for the confidence you place in our team and advice. We look forward to guiding you along the next step of your investment journey as the story continues to unfold.
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