January 2021, Year-End 2020 Investment Commentary
We said in the first quarter that we would get through this crisis and that things would improve and recover. Financial markets recovered first, quicker than they ever have from such a deep economic hole and quicker than anyone could have hoped. Economies have made great progress too but are not back to their pre-COVID-19 levels yet and may not be for another year or two. On the health side, the authorities warn us we may be in for dark days this winter before the vaccines can be widely available to the general populace. This may set back economies and markets in the near term and keep us isolated and sheltering in place in some cases. But we expect that 2021 will see the end of the pandemic, and our society can then follow markets and the economy is bouncing back as well.
In the meantime, our wish remains the same as it was in April, that you and your loved ones stay safe and healthy.
Fourth Quarter & 2020 Market Recap
As we close out a tragic and turbulent year here’s where the financial markets stand.
Global stocks ended the year at all-time highs with a 16.3% gain. It hardly needs saying, but during the dark days of March, with pandemic fears rampant and the global economy falling off a cliff, very few if any market observers would have predicted this outcome. We wouldn’t have either, but then, we avoid short-term market predictions about any event. What we did write in concluding our first-quarter investment commentary was: “Stay the course… This too shall pass.” This is generally wise (albeit clichéd) advice for long-term investors following a disciplined investment strategy. And it proved prescient once again.
In 2020, U.S. stocks led the major global equity markets. The S&P 500 gained 18.4% for the year. Small-caps finished a most remarkable year with a 31.4% gain for 4Q20, the best quarter in the more than 40-year history of the Russell 2000 Index—and after beginning the year with the largest ever quarterly loss in the index’s history. Developed international stocks finished the year up 7.8% while emerging market (EM) stocks closed up 18.3%.
In the fourth quarter, foreign stock markets were particularly strong, with gains in the mid-teens, outdistancing the S&P 500. Value stocks also beat growth stocks and small caps dominated large caps. Riskier assets in general got a boost from the resolution of presidential election uncertainty and surprisingly positive Phase 3 COVID-19 vaccine results announced in early November.
The comforting full-year returns masked the tremendous volatility and stress investors faced earlier in the year. As the chart below shows, stock markets around the world were down between 30% and 40% from January 1 to the market bottom on March 23, in what was the quickest/sharpest bear market in history. From the low point, stocks skyrocketed into year-end. The S&P 500, developed international, and EM stock indexes all roared back more than 65%. Small-cap U.S. stocks soared nearly 100%.
Moving on to fixed-income, core bonds posted a strong 6.4% for the year, providing positive returns both during and after the market crisis period. The 10-year Treasury yield touched an all-time low of 0.5% in August and ended the year at 0.93%, roughly a full percentage point below where it started 2020.
In non-core fixed income markets, high-yield bonds were up 7.1% for the year and emerging market credit ended the year up 5.3%. Both asset classes materially outperformed core bonds during the last three quarters of the year, but still have some ground to make up from the panicked market dislocations in March.
Key Drivers of Our 2020 Portfolio Performance
In a challenging and chaotic year, we are pleased to report our portfolios performed well.
We made two key allocation changes to our portfolio allocations during the first quarter, both of which added value. In late-March, as stocks were plunging and investor fear was rampant, we brought U.S. equity exposure back to targets (requiring in some cases a meaningful increase to then current equity investments). The S&P 500 is up 54% from that trade date. Additionally, with yields over 10%, we added to high yield bonds which were at their most attractive levels since the fourth quarter of 2008. Total returns on our high yield trades increased 36%.
More broadly, our portfolios produced strong performance in the second half of the year as financial markets recovered from the sharp, pandemic-induced selloff and started looking ahead to a global economic recovery. In addition to our EM equity overweight, we benefited from the aggregate outperformance of our active equity and fixed-income/bond fund managers relative to passive index benchmarks. Our non-core fixed-income allocations generated absolute returns meaningfully higher than core bonds while trailing the strong equity market rebound, as we would expect.
Macro & Market Outlook: 2021 & Beyond—Reasons for Optimism
Macroeconomic Backdrop & Outlook
Unfortunately, any discussion of the big-picture outlook must still begin with the COVID-19 health crisis and its recent “third wave” resurgence in the United States and second wave surge in many other countries, particularly across Europe. The public health impact in the United States is increasingly severe, reaching all-time highs in daily deaths (3,800-plus) and current hospitalizations (130,000-plus).
This is leading to increasingly aggressive—albeit still localized—economic lockdowns across the country. And that raises the risk of a sharp slowdown in the economy, if not an outright contraction, heading into 2021. Recent weak labor market data (weekly initial claims for unemployment insurance have been rising again), falling household income (down 1.1% in November), and slumping retail sales (down 1.1% in November, the largest decline since April and the biggest November monthly drop since 2008) indicate this is already happening. At their mid-December meeting, the Fed reiterated yet again that “the path of the economy will depend significantly on the course of the virus.” Along with the pandemic surge, the expiration of emergency federal aid programs for individuals and small businesses is contributing to the economic slowdown.
A lack of further government support would present a major near-term risk to the economy. Commenting on this situation in mid-December, Fed chair Jerome Powell said, “It looks like a time when what is really needed is fiscal policy.”
Thankfully, after months of political bickering and delay, congressional Republicans and Democrats reached agreement in the eleventh hour on a compromise $900 billion pandemic relief bill. Among its key provisions, it will make direct payments of $600 to qualifying individuals, extend $300 per week in extra unemployment benefits through mid-March, and authorize nearly $300 million in forgivable loans to small businesses. More fiscal aid may be requested in the early months of President-elect Joe Biden’s administration, including money for strapped state and local government budgets.
While the economy faces these very-near-term dangers, the likelihood of widespread distribution of effective vaccines in the first half of 2021 supports the case for a relatively strong economic rebound beginning in the second or third quarter—barring a derailment of the vaccine rollout or some other shock—as lockdowns are lifted and pent-up consumer and business spending is released.
This is a consensus view. For example, the International Monetary Fund (IMF) currently forecasts 5.2% global real GDP growth in 2021; this compares to a -4.4% global economic contraction in 2020 and 2.8% growth in 2019. For the U.S. and emerging economies, the IMF forecasts 3.1% and 6.0% real GDP growth, respectively, in 2021. Among some of the independent research services we subscribe to, Capital Economics forecasts 6.8% global GDP growth and 5% GDP growth for the United States; and Ned Davis Research forecasts 5.8% and 4.6%, respectively. These are all well above long-term historical average growth rates. The Fed is more conservative with a 4.2% U.S. GDP growth forecast for next year.
Critically, even if these forecasts are in the ballpark and we do get a decent economic recovery next year, monetary policy is almost certain to remain very accommodative/loose/stimulative. The Fed continues to communicate it is far (several years) from seeing a need to start tightening policy, either in terms of raising the federal funds rate (currently near zero) or reducing its quantitative easing (QE) asset purchases (currently at a rate of $120 billion per month).
The recent rollout of the Fed’s “average inflation targeting” framework is further evidence of their apparent commitment to achieving “maximum employment” and core inflation “moderately above” their 2% long-term target before they start to raise interest rates. Currently, most Federal Open Market Committee (FOMC) participants don’t expect that to happen until at least 2024. Of course, that is subject to change, and the Fed’s track record of predicting even their own behavior is quite blemished. But barring an extreme inflationary shock, the Fed’s current stance is likely to sustain for at least the next year or two. The Fed is forecasting core inflation of 1.8% in 2021 and 1.9% in 2022.
In 2021, inflation should get a boost from the economic recovery—and may temporarily rise above a 2% rate on a year-over-year basis compared to depressed 2020 price levels. But inflation is unlikely to move sustainably or significantly higher—again absent an external shock—as long as there remains high unemployment and excess economic capacity (the economy is still operating below its potential). The Fed is forecasting a 5.0% unemployment rate for 2021 and 4.2% in 2022.
So, short-term interest rates should remain near zero. Longer-term government bond yields may rise moderately as the pandemic (hopefully) recedes and investors start to price in a more normal economic recovery cycle. But, if it wants, the Fed has tools to contain yield increases farther out on the maturity spectrum (for example, it can start buying more intermediate- and longer-term bonds within its QE program).
In 2021, fiscal policy is unlikely to be restrictive and could be stimulative depending on political outcomes, compromises, and the usual horse-trading. As we write this, it appears the Democrats have won the January 5 special runoffs for Georgia’s two Senate seats. This increases the odds of larger fiscal stimulus, possibly offset to some extent by corporate and individual tax increases. But even with Democrats in control of the Executive and Legislative branches, they likely still won’t get everything they want. There are many fiscally minded Democrats that will moderate the new administration’s proposals (especially on taxes). One would think politicians’ self-interest (not to mention the common interest) would prevail in that event and lead to other compromise packages.
With the above as a reasonable short-term (12-month) macroeconomic base case we’ll move on to what the implications might be for financial markets.
In a nutshell, an economy in the early stages of cyclical recovery, assisted by highly accommodative monetary policy, and, at worst, neutral fiscal policy, should provide a supportive backdrop for stocks and other “risk assets” over the course of the next year.
Global Equities Outlook
In an environment in which the U.S. and global economies are in a synchronized early-cycle growth phase, corporate profits should be strong. Consensus estimates are for S&P 500 operating earnings-per-share growth of 38% in 2021, after a 23% drop in 2020. And monetary policy is loose, which should be fundamentally positive for risk assets such as stocks and “non-core” (lower-credit-quality) bonds.
As we’ve discussed in prior commentaries, in this environment of extremely low bond yields, U.S. stocks still look relatively attractive compared to core bonds or Treasury bonds. This relative valuation perspective has dominated market behavior for several years—memorialized in the acronym TINA (there is no alternative). Meaning, with core bond yields so low, investors have “no choice” but to move out on the risk spectrum and buy stocks and other riskier assets to try to meet their investment return and income objectives.
Foreign equity markets should be even stronger beneficiaries of a global recovery, given their generally higher cyclical sensitivity to global growth—a trait that has hurt them throughout the generally lackluster economic period since the 2008 financial crisis. Plus, as we’ve highlighted for the past several years, they have significantly lower valuations compared to U.S. stocks.
So, we see potential for better-than-expected earnings growth and possibly also some increase in valuation multiples for stock markets outside the United States. As such, we remain overweight to EM stocks, where our conviction is highest, funded from an underweight to U.S. large cap stocks.
In addition to partly shifting from U.S. stocks to emerging market stocks in the near term, many of the above points also apply to the cyclical/value stocks vs. growth stocks debate. The former have performed poorly, most recently by the pandemic, before that by the U.S.-China trade war, and, most broadly, by this extended period of low growth, low inflation, and very low interest rates that has strongly favored large-cap tech/growth stocks. But as the global economy recovers, these underperforming and out-of-favor stocks should show some life. Once the pandemic is perceived as under control and the economy is in a sustained upswing, we would expect “value” to have its day in the sun again, after an unprecedented 13-year run of massive underperformance. We’ve already seen this since the Pfizer vaccine announcement in November.
U.S. Dollar Outlook
The direction of the U.S. dollar is another important variable for foreign markets and the global economy. When the dollar depreciates, it increases the return to dollar-based (unhedged) investors in foreign assets, and vice versa. A weakening dollar also eases global financial conditions and bolsters global economic growth by easing the cost of dollar-based debt for foreign borrowers. Emerging markets, in particular, have historically been beneficiaries of dollar weakening and looser financial conditions.
We are not in the business of predicting currency moves, but the dollar is typically viewed as a safe-haven (risk-off) currency. It tends to appreciate and depreciate in a broadly “counter-cyclical” fashion, meaning it tends to move in the opposite direction of the global business cycle. So, a rebound in the global economy in 2021 should be a negative for the dollar relative to other more pro-cyclical currencies in both international developed countries (like the euro) and emerging markets.
There are other dollar headwinds as well: (1) With the Fed rate cuts in 2020, U.S. bond yields are relatively less attractive than they were a year ago, so there is relatively less demand for U.S. dollars; (2) the dollar is expensive on a fundamental valuation basis; (3) a growing U.S. trade deficit implies downward pressure on the dollar; (4) the technical trend (momentum) has turned negative for the dollar and has further room to run in a self-reinforcing cycle; and (5) neither the Fed nor the U.S. government want a stronger dollar, as it has deflationary implications.
The outlook for fixed-income is relatively more certain (with a narrower range of potential outcomes) than for equities given the tight mathematical relationship between bond market yields and total returns. Given the 1.03% current yield for the core bond index, we have a high degree of confidence that core bonds’ five-year expected returns will be in the 1% ballpark. On an after-inflation basis—assuming roughly 2% inflation—their “real yield” is negative. So, from an absolute- and relative-return standpoint, core bonds are very unattractive (although there are opportunities for active management to do better than the index by investing in investment-grade bond sectors not included in the index, such as asset-backed securities).
However, core bonds still play a vital risk management role in our balanced portfolios. They provide “ballast,” or safe-haven protection and positive return potential in the event of a recessionary or deflationary shock. The pandemic was the most recent example. So, we maintain meaningful exposure to core bonds with higher allocations in our more conservative/risk-sensitive portfolios. However, given the very strong rally in Treasuries (with the 10-year yield below 1%), our allocation to intermediate-term Treasury bonds is under review by our research team.
Our positions in flexible, multisector, credit-oriented bond funds and emerging market bond funds should outperform core bonds in this scenario, benefiting from both their higher yields as well as potential price appreciation/yield-spread tightening (a decline in the extra yield investors require as compensation for default risk expressed by rising bond prices). Again, we have already been seeing this happen in the second half of 2020.
For 2021, we think a reasonable base case is that the widespread distribution of vaccines (along with testing, treatment, and other public health responses) is effective in bringing the pandemic under control. This will enable the U.S. and global economies to stage a reasonably robust growth recovery off a still-depressed base. The recovery will be supported by ongoing highly accommodative central bank monetary policy, keeping interest rates low. And there will be enough fiscal aid to households and businesses to at least bridge the economic chasm while the pandemic rages earlier in the year.
This macro backdrop should be positive for global equity returns—particularly for undervalued international and EM stock markets and other beaten-down cyclically sensitive assets. Credit-oriented fixed-income strategies and alternative strategies should also outperform core bonds.
Our portfolios are well positioned if this consensus view plays out in 2021. However, our positioning is based not on one-year market predictions or economic forecasts that are notoriously difficult to consistently get right but on longer expected-return framework in conjunction with our shorter-term risk assessment.
If we have learned anything from financial market history, it is that one should expect the unexpected; expect to be surprised. There is no certainty, and much can go wrong in any given year. Much can also go right, such as the incredibly fast development of COVID-19 vaccines and the overwhelming bipartisan policy response to the pandemic early in the year.
Right now, we believe the consensus view is a very reasonable shorter-term base case. Nonetheless, and as always, our portfolios remain diversified across a range of assets and investments that should provide balance and resilience in the event this sanguine outlook doesn’t play out. We are prepared to respond prudently, thoughtfully, and opportunistically as unexpected events unfold, just as we did in March of 2020.
We appreciate your confidence and trust in Argent Trust. We sincerely wish everyone a healthier, happier, peaceful, and prosperous New Year.
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