A New Year!
We have a friend who makes it a point to be in bed asleep when midnight arrives on New Year’s Eve. This year, he’s made an exception to this rule. His reason: “I want to make sure that 2020 actually leaves.” And indeed, this past year has been an unusually unpleasant experience: COVID-19, over three hundred thousand disease related deaths in the U.S., government shutdowns, a global recession, a bear market in stocks, plummeting employment numbers and a closely fought and extremely partisan election, all have contributed to make 2020 the most wretched year (so far) of the twenty-first century.
And yet, despite all this misery, 2020 for equity investors has not been a complete disaster. Following precipitous declines in global equity markets — the S&P 500 fell 34% from mid-February to mid-March — equities hit record levels in December of 2020. For the total year, the S&P 500 gained 16.3%. The surprise of positive returns amid all the economic misery is a testament to the psychological power of great expectations, the material power of fiscal and monetary stimulus and the discounting power of ultra-low interest rates.
Since most of the disruptions of 2020 have arisen from the virulent spread of COVID-19, the knowledge that there are now at least two effective vaccines ready for use has improved dramatically the prospects for the future. Even the news that the rate of infections has accelerated following the Thanksgiving holiday and that most inoculations will not be available until later in the year cannot dim the positive value of having an end in sight to the lockdowns, quarantines and social distancing. And optimism for the future encourages planning and investment, the kind of “animal spirits” that breeds positive markets.
There’s a good bit of debate about the wisdom behind the fiscal and monetary stimulus that the government employed in 2020 to soften the blow of the pandemic. It is true that since governments (federal, state and municipal governments) were responsible for shutting down restaurants, sporting events, museums, schools, etc., precipitating an economic recession and high unemployment numbers, they alone were able to mitigate the pain by providing relief in the form of supplemental payments and low-cost loans. It’s the kind of relief the government often provides, through FEMA, to victims of natural disasters. This time, however, the damage is national, not regional, and the costs are in the trillions, not millions, of dollars. The relief appears to be working: after falling 31.4% in the second quarter of 2020, GDP grew 33.1% in the third quarter (although it’s still negative for the year). Many other measures of economic health portray a similar pattern of second quarter collapses followed by dramatic third quarter recoveries to levels at or slightly below their pre-pandemic state: for example, the unemployment rate rose to 14.7% in the second quarter from a low of 3.5% and now stands at 6.9%; real per capita personal consumption expenditures declined to $10,118 from a high of $12,927 and currently stand at $12,548. There’s no question that the economy is responding positively to the stimulus, but there is a concern about the cost and how it will be paid.
The stimulus, of course, is being paid by the U.S. government, which must borrow the funds, thereby increasing the national debt. This is according to the Keynesian playbook: in lean times the government borrows to stimulate economic activity and in more prosperous times, it pays down the incurred debt. Anyone who’s followed the inexorable expansion of the national debt knows that the second half of this function doesn’t occur: the last time the government paid off the national debt was in 1835, when Andrew Jackson was president. The Congressional Budget Office estimates that the budget deficit for fiscal year 2020 will be $3.3 trillion or 16% of GDP, the highest percentage since the end of WWII and triple the percentage for fiscal year 2019. This $3.3 trillion will be added to the total national debt, which already stands at $26.9 trillion and represents 127% of GDP. It’s unclear if there is a critical percentage of GDP that spells trouble for a nation’s economic health — some have argued that 90% is the critical ratio, a rate the U.S. has exceeded since 2010 — but if there is a critical ratio, we’re much closer to it than we were.
One of the troubles that increasing deficits and an ever-expanding national debt brings to a national economy is that, through the dynamics of supply and demand of government bonds, overall interest rates can rise precipitously, “crowding out” private investment. This concern seems very remote today, given the Federal Reserve’s extraordinary efforts in maintaining a low interest rate environment for the foreseeable future. This certainly mitigates the government’s cost of funds, but there are risks associated with these extraordinary efforts. The Fed promotes lower interest rates by buying Treasuries, effectively providing liquidity to the markets. In other words, through the U.S. Treasury, it prints money. In these extraordinary times, it’s printing an extraordinary amount of money, money that eventually flows into the private economy. If inflation is defined as too many dollars chasing a limited amount of goods and services, then the Fed’s actions could be setting the stage for an unpleasant bout of inflation in the future. We hasten to add, however, that the U.S. is a long way from this possibility: the rate of inflation for most of the last twenty years has held steadily around the 2% level and currently registers at 1.2%. But possible future inflation is a risk of the COVID-19 stimulus packages. We trust that the Fed will manage this risk effectively.
The Fed’s commitment to low interest rates, in conjunction with the government’s fiscal stimulus, has been critical in preventing a recession from becoming a depression, but it also has had the secondary effect of increasing the value of risk assets. If we consider that the price which the market assigns to an investment is based on the present value of a future return – then the price, or present value, should increase as the prevailing level of interest rates decline. In brief, this is the reason behind elevated equity price levels when applied to 2020 earnings (P/E of 28.3, when the thirty-year average is 16) and 2021 expected earnings (P/E of 25.7). With ten-year government rates below 1%, the market is willing to ignore 2021 (and possibly 2022) and focus its attention on the earnings of 2023 and beyond.
But, at the beginning of the new year, we should focus our attention on 2021. We would like to be optimistic about the new year. There’s good reason for hope: thanks to the vaccines, we should be able to resume our normal lives at some point during the coming year. Restaurants (at least those that are still in business) will reopen, masks will be jettisoned, schools will welcome back students, adults will return to their places of work and unemployment in the service economy should decline. Some pandemic related disruptions will probably remain: home offices and online shopping will surely be more common in 2021 than they were in 2019. Most of the “return to normal” likely will occur in the latter half of the year, which probably means that economic activity will not fully recover until the end of the new year or the beginning of the next. Since the equity markets trade on expectations, some of the improvements we anticipate in 2021 are already baked into the prices. Our hope is that even more improvements will be forthcoming. And that when the economy does return to normal, it imitates Goldilocks and follows a middle path of not too strong and not too weak. Our fear is that given the massive fiscal and monetary stimuli in place, the risks seem to favor the “too strong” path. But that’s a discussion for another day. For now, 2021 should be a big improvement over its predecessor.
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.