We’d like to start off with reiterating text from our 2020 outlook. It seems particularly appropriate not only when reflecting on 2020 but when looking ahead to 2021.
“We should always start by recognizing that no one can predict the future with precision. With myriad possible outcomes and often unforeseen variables, our investment philosophy is driven by avoiding the dire consequences that can result from being overly confident in a market forecast. Know what you own, understand how those things are likely to behave in different market environments, recognize your behavioral biases, and generally stick with a thoughtfully conceived long-term plan.”
With that in mind, the following are 12 key charts that have helped shaped our 2021 market outlook.
Politics – A Power Transition in Washington
Chart 1: Conventional wisdom after the 2016 presidential election was wrong
Prior to Trump’s election, the prevailing wisdom was that if he was elected, his administration would usher in an era of deregulation which would drive outperformance in energy and financial stocks. We now know that those sectors were the worst performers over the past four years. We never want to ignore the political backdrop, but we believe making portfolio adjustments based on the expected policy landscape can be extremely difficult.
Economic Outlook – Brighter Days Ahead
Chart 2: Consumers are much better positioned than would be typical coming out of a recession
Although we would never diminish the hardships being experienced by many, overall, the consumer remains in good shape. The combination of less spending and higher incomes (the result of the initial fiscal stimulus) means the U.S. consumer is well suited to weather the remaining economic storm. With Democrats now controlling the Senate, even more stimulus is likely early this year. That will further bolster consumer spending.
Chart 3: Interest rates again moved lower in 2020…a tailwind for future economic growth
The economy has an interest rate tailwind. The change in interest rates takes about 1-2 years to fully work through the economy. We expected the move lower in interest rates we saw throughout 2019 to have a positive impact on economic growth in 2020. This of course did not happen; however, interest rates have now moved even lower, and we believe the economy will return to its previously charted course, with leading economic indicators continuing to move higher throughout the year.
Domestic Equities – A Changing of the Guard
Chart 4: Performance leadership has been extreme
The difference in trailing ten-year returns between growth and value stood at a two standard deviation spread entering 2020. The COVID-19 induced lockdowns created tailwinds for many growth companies and stretched this difference even further, to a massive advantage of 7.2% per year, over the last decade. The last time the spread was this wide in favor of growth (the late 1990s), value stocks experienced an extended period of relative outperformance. Often, dramatic return differentials create massive valuation differentials that impact long-term relative performance.
Chart 5: Valuations matter for future returns
Using the S&P 500 as an example, the forward P/E ratio has a nearly linear relationship with average annual returns over the subsequent 10 years. Today, this means the market in general, and many growth stocks in particular should have below-average returns in the coming decade.
Chart 6: Earnings growth set to accelerate for small-cap companies
From an earnings growth standpoint, it will be the cyclically oriented areas of the market that should enjoy an advantage, as they are poised to experience a profit resurgence. While some would argue the earnings recovery in cyclical is solely a function of depressed 2020 earnings, the estimated EBITDA (Earnings before Interest, Taxes, and Depreciation & Amortization) growth rates for each quarter of 2021, using the pre-pandemic year of 2019 as a base, also supports the idea that areas such as small- cap stocks should enjoy an earnings tailwind.
International Equities – Still Cheap: A Weak Dollar & Strong China Help
Chart 7: Developed international equities are cheap versus the United States
Investors have historically awarded domestic stocks a P/E ratio of roughly 2 turns higher than developed international markets. Today, the P/E differential is closer to 6 turns higher, 2 standard deviations greater than the 20-year average.
Charts 8 and 9: A strong Chinese economy is another important tailwind
As a reminder, China represents more than 43% of the MSCI Emerging Markets Index, and the combined weight of China, Taiwan, and South Korea over 63%. The expansion of China’s credit and fiscal spending is a historically accurate indicator of future economic activity. Strong demand from China should be a boost to both emerging market, and export-oriented developed international economies.
Chart 10: A weak dollar will help support emerging markets and U.S. multinational corporations
A weakening USD should help emerging market economies, especially those that have piled on large amounts of USD denominated debt. As the USD weakens relative to certain EM currencies, the financial strains created by that dollar debt are reduced. We believe the USD will remain weak. Although many factors are at play, perhaps the most critical is that the U.S. Federal Reserve will allow inflation to move higher without increasing rates. This will perpetuate negative real (after-inflation) interest rates here in the U.S., narrowing the after-inflation benefit of owning U.S. assets for international investors. Taken in combination, our view is that the dollar remains weak, which should benefit emerging market investors.
Chart 11: Excess Liquidity = Search for Yield
We continue to favor overweight positions to investment-grade corporate bonds (versus Treasuries) across BMT’s Fixed Income Strategies, given the benign economic backdrop, higher yields, and potential for credit spreads to grind tighter. For those BMT strategies that permit non-investment-grade issuers, we believe the current credit environment is also constructive for high-yield corporate bonds and bank loans, both sectors we also favor. In addition, emerging market debt looks appealing for its diversification and high real yields relative to other fixed-income sectors.
Chart 12: Accelerating economic growth should put upward pressure on longer-term rates
In 2021, we are positioning taxable strategies for a steeper yield curve, given our view that longer-term yields will rise in conjunction with better economic growth and modestly rising inflation expectations. Here we see the relationship between economic growth (proxied by the ratio of copper prices to gold prices – industrial metal prices usually rise relative to precious metals in an economic expansion) and long-term interest rates.