Better Late Than Never
Reflecting on a Year to Remember…or Perhaps to Forget
Investing should always be about the destination, not the journey. After all, where you end up is the critical consideration, with everything in between simply being “noise.” However, it is often the nature of the journey that determines your destination. A smooth ride with little volatility makes it far easier to stick with the plan and reap the rewards of a well-constructed portfolio. Conversely, unexpected events that create significant market volatility breed restlessness, making it easy to question one’s strategy and make rash decisions. In investing, as in life, progress often happens too slowly to notice, while setbacks happen too fast to ignore. Intuitively, we all understand that staying the course is almost always the best medicine but, in the moment, that prescription can be a bitter pill.
Enter 2020…The world threw everything it could at investors this past year, but the market’s resilience was on full display, with the S&P 500 finishing the year up 16.3%. Although some may argue it was more about jaw-dropping monetary and fiscal stimulus than it was about natural resilience, investors would have been hard-pressed to predict the stock market’s record-setting decline or equally impressive recovery.
For this reason, we reiterate 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.”
2021 – Better Late Than Never
As we look to the year ahead, one will note many similarities with our themes from 2020. Prevailing fundamentals entering 2020 were highjacked by COVID-19, making a natural progression of the economic cycle impossible. We believe self-imposed economic impediments will begin to fade in the second quarter of 2021, with large amounts of stimulus bridging the gap between now and then. This will allow many of our key themes from 2020 to finally emerge. As the title suggests, better late than never.
We will undoubtedly face challenges this year, particularly amid a transition in political power, increasing virus cases, and the endlessly complex logistical challenge of disseminating a new vaccine across the world. That said, we appear to have avoided a political outcome that may have led to extreme policy changes, monetary policy will remain supportive, and the market’s anticipation of a broadly available vaccine should provide investors some level of comfort even as virus cases increase.
Key 2021 Themes: accommodative monetary policy; more fiscal stimulus; a benign power transition in Washington, D.C.; the return of corporate earnings; the return of economic activity; value and small-cap have their day; a weak dollar; a strong China; higher, but still historically low interest rates.
The following will provide more detail supporting our outlook for 2021.
Politics – A Power Transition in Washington
The dominant narrative before the election was that a “blue wave” would benefit financial markets because it would lead to a large and more immediate fiscal stimulus package. The narrative evolved to “gridlock is good” because significantly higher taxes and business regulation are unlikely under a divided government. The most recent iteration, post-Georgia Senate elections, is that additional stimulus and only modest tax increases will propel the market higher. The lesson here is that Wall Street is good at creating an explanation for however the market decides to behave.
All political judgments aside, we believe some important themes are as follows:
Democrats have razor-thin House and Senate majorities: We are not dealing with a “blue wave” scenario, and while policy priorities may shift due to the Georgia Senate results, we don’t think this will be a “game changer.” The blue wave scenario, would have been 53-55 Democrats in the Senate, and may have led to things like a removal of the filibuster and adding new states (D.C. and Puerto Rico). The Georgia result is more nuanced, with Democrats holding a 50-50 Senate and many Democrats representing states that can vote Republican in 2022 and 2024. The composition of the House is similar, and Democratic members representing traditionally GOP districts will be a governor on more extreme policy proposals.
While the extreme changes are not likely, the policy outcomes that are now possible are as follows:
Two new stimulus bills. The first in February or March would include $2,000 direct payments, aid to state and local governments, more unemployment spending, and possibly an expansion of the Earned Income Tax Credit. The second bill will be more difficult to pass and involve $1 to $1.5 trillion of new spending on infrastructure, climate change, and healthcare. Since this bill will be done through the budget reconciliation process, the spending will need to be offset via higher taxes and possibly cuts to pharmaceutical reimbursements. Top marginal tax rates, corporate tax rates, and potentially capital gains and dividends taxes could go higher, but not nearly as much as they would have under a clearer majority for Democrats.
Investors will need to price in additional fiscal stimulus in 2021, but also the potential for higher corporate taxes (lower earnings) in 2022 and 2023. Regardless of overall market direction, we believe this sets up well for mid/small cap companies, cyclically oriented sectors, and value stocks.
Pressure on the U.S. dollar: We will see executive action on trade, as we saw with Trump. The imposition of tariffs by the U.S. disproportionally hurts foreign countries. The removal of such tariffs (which is likely under Biden) will therefore disproportionally benefit international economies. Because currency values are relative, this would be dollar negative. In our view this will benefit international equities, especially emerging markets that carry large amounts of U.S. dollar-denominated debt. We continue to recommend meaningful international equity exposure in our strategic asset allocations.
Vaccine and stimulus: We thought the vaccine news would counterintuitively be the impetus for another round of fiscal stimulus. We were correct in that assessment. Policymakers believe they are building a very specific bridge from today to a time where activity can return to normal, so the additional spending was more palatable for both sides. Because the endgame appears far clearer, the fear of “throwing good money after bad” is greatly reduced. Logic might suggest otherwise because if we are closer to achieving normalcy, we shouldn’t need additional stimulus. However, we still have millions of people not working, retail sales growth is slowing, and we will continue to see more restrictions because of the virus. Therefore, we think stimulus is needed if stocks want to avoid a meaningful setback earlier in 2021. With Democrats now holding a narrow majority in Congress, even more stimulus is very likely.
The Fed will keep the pedal to the metal: longer maturity interest rates will likely drift higher while remaining exceptionally low by historical standards. In our view, this will perpetuate a gravitational pull toward equities. When over 80% of large investors like Public Pension funds have annual return targets of over 7%, they must own stocks, regardless of who controls Washington. This is an important counterbalance to changes in policy that could impact things like capital gains taxes.
Politics in Perspective
As discussed in the introduction, human nature makes inaction difficult when faced with major change. The 2020 U.S. Presidential Election is a perfect example of this phenomenon, and it is natural to want to make investment changes based on the election outcome.
It is our view, however, that most people are overestimating the election as a lasting market driver. As unpopular an opinion as this may be, elections rarely prove to be turning points in the prevailing market cycle. In 1980, stocks were weak after the election of Ronald Reagan and remained that way until the recession ended in 1982 and the Fed instituted more accommodative policy. How about Clinton in the 1990s? The reality is that stocks were already recovering when he was elected, and the largest gains of the decade didn’t start until 1994 when policy become gridlocked. Even capital gains tax increases in 1986 and 2013 didn’t derail strong bull markets.
To quote Mike Santolli of CNBC, “In order to treat an election as a specific catalyst for investment moves, one would have to handicap the result, anticipate the makeup of Congress, intuit the key policy priorities, evaluate the likelihood of them becoming law, estimate their economic impact and then determine how much of this decision tree has already been priced into financial markets. Sound possible?” Donald Trump’s election in 2016 is the latest reminder of how hard it is to divine market performance from political outcomes. 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.
We are optimistic about financial markets in 2021. Many investors agree with this assessment, but less agree on the primary driver of market returns. Will it be an improvement in economic fundamentals, or will it be the stimulus-driven low-interest rate environment that continues to push investors out the risk curve into stocks? In our opinion, both can and will be true. For the first time in several years, global monetary policy and fundamental economic growth will be rowing in the same direction. Global central banks will keep interest rates historically low and continue to expand their balance sheets, but we think the predominant market driver (especially in terms of what asset classes lead the market higher) will be stronger global economic growth. We think this will create a typical post-recession market pattern, including better relative performance in small-cap and cyclical/value stocks. This should also support our view of a weaker dollar, strong performance in corporate credit, and somewhat higher interest rates on the longer end of the yield curve. The likelihood of even more fiscal stimulus will serve as added fuel to this view.
Well Positioned for Improvement – Fiscal Support and a Solid Consumer
There were clear signs of slowing economic momentum heading into the end of 2020. As COVID-19 cases ticked steadily higher, many business restrictions were renewed, putting pressure on the labor market recovery, retail sales, and consumer confidence. Although the U.S. economy continues to add jobs, Chart 1 shows the pace is slowing. With millions more people unemployed today versus this time last year, any loss in momentum is concerning given roughly 70% of U.S. GDP is consumer spending.
Chart 1: Labor Market Momentum Has Slowed in Recent Month
Even with this backdrop, we have a glass-half-full outlook. Part of this view is driven by confidence in additional fiscal stimulus and vaccine distribution, but we think the current resiliency of economic fundamentals should not be overlooked. 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 (Chart 2).
Chart 2: Consumers Spent Less and “Earned” More in 2020
Although an unusual post-recession condition, we see this reality playing out in consumer behavior. For example, apartment tenants are still paying their rent. Using data through November 20, the National Multi-Family Housing Council reported that 94.8% of tenants were paying their rent. This compares to a slightly higher, but not dramatically so, 96.6% the prior year. Other consumer delinquency data tells the same story (Chart 3).
Chart 3: Contrary to Intuition, Delinquency Rates Have Not Budged
Although this data will likely deteriorate some over the next couple of months, our belief that policymakers will pass additional stimulus in early 2021 makes it hard for us to have a negative view of the economy over the next 12-months. As some degree of confirmation, interest rates have ticked steadily higher since August. If bond investors were anticipating another severe/prolonged economic slowdown, it would be unusual to see this kind of buoyancy in interest rates. The 10-year Treasury rate has steadily increased from a low of 0.51% in early August to 1.00% as of the time of this writing.
Another Critical Tailwind – Interest Rates
There are numerous leading economic indicators one can use as a proxy for the business cycle, and we feel the Conference Board’s composite index of ten leading economic indicators (LEI) is a useful tool. As seen in Chart 4, the year-over-year change in the LEI has always turned negative anywhere from a couple of months to a couple of years prior to a recession. In 2020, this was not the case. In fact, the year-over-year change in the LEI was moving higher when the recession started. In our view, economic momentum was accelerating before the pandemic, but the business cycle was short-circuited by the virus-induced lockdowns. To quote our 2020 outlook, “Recessions are typically caused by a central bank policy blunder (raising rates too aggressively), an excessive build-up of inventory, an asset/credit bubble, high levels of inflation, or a black swan event. Black swan events are definitionally unforeseeable.” We got the mother of all black swans in 2020, and along with it one of the most unusual recessions we have ever seen.
Chart 4: YoY % Change in the LEI was Rising Heading into 2020
Even with persistent virus-related challenges, we think the combination of additional fiscal support, a strong consumer, and eventually a widely available vaccine will be enough to avoid another severe economic slowdown.
In addition, the economy has an interest rate tailwind. The relationship between the change in interest rates and the economic cycle is displayed in Chart 5. 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.
Chart 5: As Lower Rates Benefit the Economy, the LEI will Continue Higher
As leading economic indicators such as the LEI reaccelerate, the market typically behaves a certain way. Interestingly, although growth stocks have dominated value stocks throughout this expansion (especially in 2020), the two most consistent periods of value outperformance began just prior to a bottoming in the LEI index. Our belief is that we are again approaching such an inflection point and that it may prove beneficial to value-oriented strategies (Chart 6). Given the extreme nature of the recent underperformance of value, we think there will be a big catch-up trade in 2021.
Chart 6: Value Stocks Often Perform Better When Growth Reaccelerates
Similarly, small-cap stocks often outperform large-cap stocks coming out of recessions. Our largest exposure tilt relative to the passive market is toward mid- and small-cap, and we expect the reacceleration of economic growth this year, driven by the vaccine, will lead to outperformance from those asset classes (Chart 7).
Chart 7: Small Cap Stocks are Beginning to Outperform Large Cap Stocks
The unprecedented support from central banks and fiscal authorities is not strictly a U.S. phenomenon. Table 1 puts the liquidity injection across the globe into perspective. The combination of monetary and fiscal stimulus in the Eurozone and Japan, as a percentage of GDP, was approximately 50% and 74%, respectively, in 2020.
Table 1: Stimulus is a Global Phenomenon
European countries instituted more aggressive lockdown measures to halt the second wave of virus infections. As a result, the region will likely experience negative GDP growth in Q4. However, Europe seems well-positioned for a strong post-vaccine recovery after being in a more precarious position compared to the United States prior to the pandemic. The European economy tends to be more cyclical and more dependent on global trade, which should get a boost from rising demand in China. The Chinese economy was the first to enter the recession, and it was the first to recover. Various economic reports out of China reveal that activity has resumed to levels preceding the pandemic. According to the International Monetary Fund, China is the only G20 nation that will experience positive GDP Growth in 2020. International stocks generally fare better than their U.S. counterparts when global growth recovers, which is our base case scenario for 2021.
Heading into 2020, the small-cap segment of the U.S. equity market had massively underperformed large-cap over the trailing three years, with the S&P 500 producing compound average annual returns of 15.25% vs. just 8.56% for the Russell 2000 Index. Similarly, value-oriented equities dramatically underperformed growth stocks over the same time period. With the Fed working to reverse the rate hikes they enacted from 2015-2018, and unemployment hovering near 50-year lows, economic activity looked poised to reaccelerate as 2020 began – a friendly condition for both small-cap and value.
In short order, however, the pandemic derailed that thesis. The shutdown of vast segments of the economy was punishing to most businesses, however many technology (growth) companies were in fact well suited for the “stay at home” era. The top five holdings within the S&P 500, each of which is tech- oriented, provide stark evidence of this advantage. At October month-end, the top five names had advanced an average of over 38% year-to-date. Given their outsized weights within the Index, those five companies alone pushed the S&P 500 higher by roughly 6.6%. With the entire Index only up 2.8% at that time, by definition, the remaining 495 names pulled the return lower by nearly -4.0%. Clearly the antithesis of broad market participation.
This lopsided performance profile manifested in the valuation gap depicted in Chart 8. Here, the trailing twelve-month price-to-earnings (P/E) ratio is shown for the Index as a whole, along with the Top 5 and the remaining 495 companies. While P/E ratios moved higher for each group, for the bottom 495 and the Index itself, that was mostly driven by falling earnings brought on by the pandemic. For the top five, calendar 2020 earnings actually increased at each company, so the huge increase in the P/E multiple is not a function of depressed earnings. Instead, it is mostly attributable to investors paying a greater and greater premium for those earnings.
Chart 8: Investors Huddled into a Few, Expensive Companies
Comparing growth versus value stocks tells a similarly dramatic story. Chart 9 details the difference in trailing ten-year returns, which entering 2020 stood at a two standard deviation spread. 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 (late 1990s), value stocks experienced an extended period of relative outperformance.
Chart 9: An Extreme Performance Difference
While we concede that valuation is not a good timing tool, it is noteworthy that over the past three decades, when the return differential between growth and value has moved beyond two standard deviations, in either direction, it has led to a reversal of leadership.
Recently, this spread started to narrow slightly. This “turn” was brought on by various pieces of positive vaccine trial news during the month of November. The market reacted swiftly to this information, with small-cap and value equities surging relative to large-cap growth (Chart 10).
Chart 10: The Start of a Persistent Trend? We Think So.
While one month does not a trend make, we believe that areas of the market that were severely punished during the lockdown should enjoy a sustained and disproportionate benefit as the economy reopens. This rebound will have an outsized positive impact on small-cap and value issues, two segments of the market with much greater exposure to cyclically oriented stocks. As we know, the price you pay should also be the primary driver of longer-term term expectations. Using the S&P 500 as an example, Chart 11 shows the forward P/E ratio has a nearly linear relationship with average annual returns over the subsequent 10 years.
Chart 11: Valuation Still Matters for Long-Term Returns
Earnings Outlook – The Opposite of 2020
When final figures are tallied for 2020 S&P 500 earnings, the Index will likely suffer an earnings decline of roughly -15%. For calendar 2021, FactSet consensus estimates show that the decline will be more than fully recovered, with S&P 500 earnings surging to an all-time high, something which seemed unfathomable just a few short months ago.
Still, analysts tend to be overly optimistic with respect to earnings estimates at the outset of the year, and then reduce those estimates as the year unfolds. With this in mind, one could easily view current S&P 500 estimates for 2021 as overly optimistic. However, looking at this dynamic through at least one lens would lead to a different conclusion. As Chart 12 displays, the uptick in ISM orders relative to inventories indicates that current consensus estimates are likely to move even higher over the coming months. The logic here is that the backlog of orders is increasing relative to existing inventories, which will lead to increased corporate production to meet demand, resulting in earnings that are higher than current estimates.
Chart 12: Pent Up Demand Should Support Earnings
As discussed in the previous section, valuations are above average across the board. That said, the relative value lies within asset classes like small cap, value, and cyclically oriented equities. Less earnings good news is priced into those areas of the market, therefore we believe they stand to benefit much more from a reacceleration in profits.
Rotation Commentary – Desirable Exposures
Diversification, as opposed to Concentration, pays off in 2021.
The Russell 3000 Growth Index has a huge concentration in technology issues, dwarfing what exists within value and small-cap. However, we would argue that the information technology weight actually understates the tech-oriented makeup of that Index, as large swaths of the Consumer Discretionary (Amazon) and Communications Services (Facebook and Alphabet) sector within the Growth Index are tech-oriented. Applying a more liberal definition would easily move the tech weighting to roughly 60% within the Growth Index – a lopsided exposure that paid dividends for this style over the recent past. Conversely, certain cyclical exposures (industrials, financials, real estate, materials) are modest percentages within the Growth Index, with far higher representation in value and small-cap (Chart 13).
Chart 13: Growth Indexes are Far Less Diversified
From an earnings growth standpoint, it will actually 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 cyclicals is solely a function of depressed 2020 earnings, Chart 14 below forcefully argues otherwise. This chart shows the estimated EBITDA (Earnings Before Interest, Taxes, and Depreciation & Amortization) growth rates for large and small-cap stocks for each quarter of 2021 but uses the pre-pandemic year of 2019 as a base. While the first quarter shows little difference between the two, the difference becomes yawning over the balance of the year.
Chart 14: Earnings Growth Favors Small Over Large
The rebound in small-cap EBITDA is obviously tied to the greater exposure to cyclicals down the cap spectrum. Parsing the large-cap universe between growth and value, as discussed earlier, shows a similar bias to cyclicals. That outsized exposure to cyclicals, coupled with the resulting valuation difference between value and growth, also sets value-oriented issues up for a strong showing in 2021.
When we entered calendar 2020, we believed small-cap and value would outperform relative to large-cap and growth. The pandemic did not scuttle that thesis, but it did delay it for most of the year. As to Large-Cap Growth, while those stocks will participate in the market’s move higher in 2021, we think that their streak of outperformance will end.
Developed International Equities
The underperformance of international equity markets continued in 2020 with the MSCI EAFE Index trailing the S&P 500 by 11.3%. Index construction explains much of this underperformance. As previously noted, the outperformance of growth stocks (technology in particular) was dramatic in 2020. The information technology sector now constitutes almost 28% of the S&P 500 vs. only 13% in Japan and 11% in the Euro Area.
As a result of this difference in sector exposure, corporate earnings in international markets were impacted to a much greater degree than here in the United States. S&P 500 earnings are expected to be down 15% in 2020, while MSCI EAFE earnings are estimated to be down 25%. Even with this earnings advantage, U.S. stock prices continue to be very expensive when compared to international stocks by historical standards. The difference in index sector composition justifies part of this differential, however, the current spread is extreme. As depicted in Chart 15, 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.
Chart 15: Another Valuation Extreme We Expect to Reverse
Heading into 2020, the key question we posed was, “what will be the catalyst that drives international equities to close at least some of the valuation gap and reverse a decade of relative underperformance.” Last year, we pointed to evidence of a bottoming in manufacturing PMIs, which is particularly important in foreign economies that are more reliant on industrial output than the U.S., leading to an earnings recovery after several years of essentially flat earnings for international stocks. The pandemic certainly disrupted this anticipated earnings recovery in 2020, but we again appear poised to see a reacceleration in global economic activity which should benefit developed international markets. Cyclical stocks are disproportionately represented in international markets (Chart 16), and estimates call for a 30% rebound in earnings for the MSCI EAFE Index versus a 21% bounce for the S&P 500 Index.
Chart 16: International Stock Indexes are More Levered Toward Cyclicality
While it is still early, Chart 17 shows that we started to see a turn toward global and cyclical stocks recently, in anticipation of a new global business cycle.
Chart 17: Relative Performance Fortunes are Starting to Turn
**Cyclical sectors include semiconductors, materials, and industrial. Defensive sectors include utilities, consumer staples, and healthcare. *MSCI global value and growth indexes
We were neutral on Emerging Market Equities (EM) in 2020 within our strategic equity asset allocation (7% of total equity exposure). Although we believed EM stocks had already started to price in the improving economic environment of the region, as well as some euphoria from the U.S.-China Phase One trade deal, we still believed the combination of reasonable valuations, a weaker dollar, and a continuation of global growth warranted a meaningful allocation. Through December 10, this positioning has largely proved beneficial as the MSCI Emerging Markets Index had a total return of 15.1%, while Developed International stocks and the S&P 500 returned 5.8% and 15.5%, respectively. Although robust global growth was not the catalyst, EM stocks benefitted from a rapid post-pandemic recovery in China and a weakening U.S. dollar.
Ghosts of EM Past & Present
Solid performance in EM stocks during a global recession may seem counterintuitive. Mention “Emerging Markets” and images of commodities and heavy industry likely flash before your eyes. This perception is largely true from an economic sense, but it is no longer an accurate representation when you peek under the hood of the EM stock Index. Over the past several years, the maturation of Asia’s technology and internet sectors has shifted the EM Index to look less cyclical. Tables 2 and 3 below compare the evolution of the EM market on a sector basis between 2012 and late-2020, as well as the substantial change in weight for the top three holdings. Like U.S. markets, technology and internet-related or “New Economy” stocks were the largest contributors to EM performance. As the world locked down and digital transformation advanced, demand for advanced computer chips to enable remote-work and learning propelled Samsung Electronics and Taiwan Semiconductor Manufacturing to new highs. Similarly, e-commerce, cloud computing, and online gaming drove Alibaba Group Holding Ltd. and Tencent Holdings to set new records.
The Year Ahead
Following a challenging year, emerging market economies are poised for expansion. High levels of government stimulus in the wake of the global health crisis should fuel EM economies in 2021. The pace of recovery among EM countries will differ greatly with some regions struggling to control the coronavirus, but China remains the critical region. 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%. Chart 18 depicts the expansion of China’s credit and fiscal spending, a historically accurate indicator of future economic activity. Although the Chinese government has recently started to tighten credit availability, it seems unlikely that China will significantly restrict policy as it looks to support its economy before the 100th anniversary of the founding of the Chinese Communist Party (CCP) late in 2021. We also believe more moderate levels of fiscal and monetary expansion may help avoid the typical boom/bust cycle we often see within China, preserving the longevity of the current expansion.
Chart 18: Liquidity Expansion Would Indicate Strong Future Growth
A Weaker U.S. dollar (USD) is a Tailwind for Emerging Markets 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. Chart 19 shows the U.S. dollar inverted on the left axis versus emerging market stocks on the right axis. The inverse relationship over the past five years between the USD and emerging market equities is clear.
Chart 19: USD Down, EM Stock Up
Crisis and economic uncertainty drive investors to “safe-haven” assets like the U.S. dollar. Look no further than March of 2020, when the USD spiked 10% amid the initial outbreak of COVID-19. Since that point, through a combination of massive stimulus and positive vaccine developments, the global economy looks poised to reaccelerate. As such, the dollar has steadily weakened since March. A reduction of global uncertainty and a more trade/China-friendly Biden administration should keep pressure on the greenback in 2021. Massive current account and budget deficits are also a likely dollar headwind. Perhaps most importantly, the U.S. Federal Reserve will allow inflation to move higher without increasing rates. This will perpetuate negative real 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.
Positioning in 2021: Not Too Hot, Not Too Cold
We reiterate our neutral positioning to Emerging Market equities for 2021. We think a global economic recovery will provide support, but a less-cyclical stock index keeps us from dialing up the exposure even more. EM markets likely reflect some of this recovery already, and the evolution of market construction won’t provide as much of a cyclical upswing as in years past. That said, relative valuations in EM still appear attractive (Table 4), and a strong Chinese economy will provide an opportunity for further gains. Our neutral stance is less about a negative view (in fact we expect another year of solid returns), but rather more positive expectations for developed international markets. Developed international markets, and the many export-driven economies therein, should also benefit from an expansion in China and generally accelerating global growth. As shown in the sector breakdown above, the MSCI EAFE Index is far more cyclical than both emerging markets and the United States.
Our outlook for fixed income is, of course, largely driven by our expectations for fiscal stimulus, economic growth, and monetary policy. In summary, we believe the dissemination of COVID-19 vaccines, additional fiscal stimulus, and aggressive monetary easing will combine to create an acceleration in economic growth. Short-term economic volatility is expected while vaccine distribution ramps up, but as households and businesses revert to pre-COVID-19 routines, economic activity will likely improve. In our view, this means a natural tendency toward higher long-term interest rates, higher inflation, and a healthy environment for credit markets. The Federal Reserve (Fed) will have their eye on increasing longer-term interest rates, and some action will likely be taken to reduce their steady climb.
Federal Reserve – Pedal to the Metal
As the pandemic threatened both economic and financial market stability at the start of 2020, the Fed intervened in dramatic fashion. This year begins with the lower bound of the federal funds target range already at 0.00%, forward guidance indicating no change to the target range through 2023, bond purchases to the tune of $120 billion per month, and a Fed balance sheet that is roughly 75% larger than a year ago.
Most of the additional emergency programs/facilities instituted to support funding markets have expired. With credit markets now functioning normally, the need to maintain such facilities is greatly diminished, in our view. The Fed stands at the ready if economic and credit conditions worsen, but we believe the Fed’s prior actions continue to provide adequate accommodation to support maximum employment and price stability – the Fed’s primary objectives.
Additional Fed Action?
Given our expectation for positive economic growth, the likelihood of market forces pushing bond yields higher will naturally increase. Chart 20 shows 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 interest rates.
Overall, we expect a less active Fed in 2021, but action will be taken to control any unwanted spikes in borrowing costs. Forward guidance, yield curve control, and bond purchases will be the primary tools used to mitigate any disorderly increase in longer-term interest rates. Given lessons from Europe (negative interest rates don’t really work), we believe negative interest rates will remain off the table here in the United States.
We expect inflation will trend higher in 2021, albeit slowly. We are of the view that the Fed will be successful in reaching their 2.0% inflation target on a sustainable basis within the next few years. Changes made to the Fed’s Statement of Long-Term Goals and Monetary Policy Strategy last year set a very high bar for removing policy accommodation prior to inflation hitting its mark. Most notably, the Fed will now explicitly tolerate inflation above 2.0% for a period. Changes also limit necessary Fed action in response to tighter labor markets, which should support inflation expectations over the medium and long-term.
Steeper U.S. Treasury Curve in 2021
We believe the U.S. Treasury yield curve will steepen in 2021, driven by a gradual rise in long-term term yields. The short end of the curve will be well anchored to monetary policy which is expected to remain very accommodative during the year. Intermediate and long-term yields will be more reactive to changing economic conditions given their sensitivity to economic growth. We believe that higher levels of economic activity will lead to rising long-term inflation expectations, and actual inflation. Longer-term yields will also be more influenced by fiscal policy, and sizeable government deficits will necessitate more U.S. Treasury bond supply – pressuring pricing down and yields up. In 2021, the deficit is expected to narrow but remain sizeable at closer to $1.8 trillion based on projections from the Congressional Budget Office. As Treasury supply increases, we expect yields to be pressured higher, with longer-term yields being the most impacted, especially given the U.S. Treasury’s focus on lengthening the average maturity of its outstanding debt.
That said, we believe the Fed will be quick to initiate more stimulus measures through additional bond purchases, further forward guidance, or other appropriate measures with the intent of keeping yields from drifting beyond the Fed’s comfort level. Frankly, it is hard to know exactly where that comfort level lies, but our guess in anything above 1.5-2.0% on the 10-year Treasury yield would elicit Fed action.
Credit Markets Healthy, but Valuation a Challenge to Meaningful Price Appreciation
The corporate bond market went on a wild ride in 2020. Credit spreads widened to levels last seen during the Financial Crisis, then reversed back to nearly where they started the year. Impressively, corporate bond investors absorbed record issuance in 2020, which will undoubtedly leave investors scrutinizing balance sheets this year. Still, the overall backdrop for corporate bonds looks appealing given accommodative monetary policy, accelerating economic growth, and the resultant rise in corporate profitability. We believe the most cyclical companies, including consumer service-related businesses, will be best positioned to take advantage of the early stages of the recovery, notably within industries that were most impacted by COVID-19 restrictions. Topline growth will support investor confidence, while risk appetite and the search for yield should positively influence investor demand. However, with credit spreads again tight by historic standards, valuations will most likely limit some of the excess performance we expect relative to U.S. government securities.
Supply and demand dynamics should help. In 2020, corporations took advantage of investor demand for credit and built balance sheet liquidity given the uncertainty surrounding COVID-19. After last year’s supply surge (Chart 21), investors will most likely have fewer deals to choose from in 2021, leading to a potential mismatch between supply and demand, supportive of valuations.
This increased supply undoubtedly added a boost to corporate cash coffers and was a welcomed improvement to balance sheet liquidity. Cash on the balance sheet of S&P 500 companies at the end of the year increased more than 30% from the prior year. However, the extra liquidity comes at the expense of more leverage, a negative for corporate fundamentals. Although partially attributable to depressed earnings in 2020, outstanding debt relative to EBITDA increased by roughly 20% in 2020 (Chart 22).
We expect corporations to better position themselves for the long-term as we move through 2021, with less focus on significant short-term liquidity buffers given the improved economic outlook. This should lead to improving leverage metrics. Monitoring this progress, and the extent of deleveraging that takes place, will be key when gauging credit quality and the overall riskiness of corporate balance sheets.
Improving credit metrics will be a positive, although current bond pricing already incorporates a healthy degree of investor optimism. The overall backdrop for credit is supportive in 2021, but it’s important to recognize that credit spreads have come a long way since reaching their post-Financial Crisis highs back in March. Today, investment-grade credit spreads are trading back to the pre-COVID-19 levels, leaving modest room for excess performance. High yield spreads aren’t too far behind (Chart 23).
We think that investment grade and high yield credit spreads have room to grind tighter as prospects for the economy improve, but the risk/return tradeoff certainly isn’t as compelling as it was earlier in 2020. Another key element here is that there is roughly $18 trillion of negative-yielding debt around the globe. We expect foreign demand will continue this year, given the attractiveness of U.S. corporate bonds relative to other lower-yielding opportunities in many international markets.
Emerging market debt is another sector that will likely benefit from the global glut of negative-yielding bonds amid the backdrop of better macro fundamentals. Emerging market debt is one of the few fixed income sectors that still offers an attractive inflation-adjusted yield for investors. Fundamentally, emerging market economies are expected to improve in line with developed market economies. A strong Chinese economy will provide additional support to commodity-driven emerging markets, while our opinion that the U.S. dollar will remain weak should be supportive of many externally financed emerging markets.
Strong Demand Continues for Municipal Bonds
The municipal bond market surprised many participants last March when AAA investment-grade yields spiked more than 200 basis points in just a matter of weeks. The safest part of the municipal market quickly unraveled as investors raced to the sidelines and liquidity was nowhere to be found. The Fed stepped in with the Municipal Bond Liquidity Facility, a positive for market stability, and municipal bonds have been on an improving trend ever since.
In 2021, we expect municipal fundamentals to benefit from a benign economic environment and a successful rollout of COVID-19 vaccines. More economic growth is generally supportive of personal and corporate tax revenues, a positive for local and state general obligation bonds. In fact, as written by Bloomberg on December 15, 2020, “The fiscal apocalypse expected to blow massive holes in state budgets hasn’t come.” State tax revenues have far surprised dire forecasts, meaning municipal credits are likely in far better shape today than almost everyone had anticipated. In our view, the outlook for municipal credit is good, although fully repairing budgets back to pre-COVID-19 days will certainly take time. In the interim, credit downgrades should be expected, but we would stop short of predicting any notable jump within investment-grade defaults.
We expect municipal bond demand will continue in 2021 as investors favor tax-free investments. The 2017 Tax Cuts and Jobs Act (TCJA) that limited state and local tax deductions to $10,000 will keep investors searching for tax-free income, most notably in the high taxed states such as California and New York.
AAA-rated municipal bonds have been the best performers in 2020 within the municipal bond market through November 2020 restoring valuation metrics back to the beginning of 2020 levels.
However, valuations among the weaker credits haven’t kept up. AAA municipal bonds through November 2020 were up 5.22% compared to A municipal bonds up 4.41%. In 2021, we expect investors will be more comfortable searching for yield within weaker credits and issuers/sectors that are more sensitive to a full reopening of the U.S. economy.
Putting it All Together – Positioning in 2021
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. Short to intermediate maturities will have less price volatility relative to longer-term maturities within a rising yield environment, and therefore, less sensitivity to extreme price changes. With bond yields starting at historically low levels, managing duration risk and targeting a shorter duration relative to each strategy’s benchmark will be a primary focus for BMT taxable fixed income strategies.
We continue to favor overweight positions to investment-grade corporate bonds across BMT’s Fixed Income Strategies given the benign economic backdrop, higher-yielding opportunities, 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 favor as well (Chart 24). In addition, emerging market debt looks appealing for its diversification and high real yields relative to other fixed-income sectors.
Chart 24: Excess Liquidity = Search for Yield
We are less enthusiastic about U.S. Treasury securities. Expected increases in supply, combined with a healthy U.S. economic outlook, leads to our underweight positioning. Both factors will put upward pressure on yields, in our view. We continue to incorporate Treasury Inflation-Protected Securities (TIPS) in the taxable strategies for their diversification benefits and the Fed’s focus on increasing inflation. We believe TIPS valuations will benefit in a rising inflationary environment. Within the BMT Core and Core Plus fixed income strategies, we also favor agency mortgage-backed securities (MBS) for the additional yield over U.S. governments, the high credit quality characteristics of MBS, and the likelihood that the Fed will remain an active purchaser of MBS in 2021.
Within tax-free municipal bonds, we are more tolerant of duration. We continue to believe that yields will trend higher as the year progresses, but not to the same extent as U.S. Treasury securities where supply concerns linger. We expect investor demand to remain robust for tax-free income, while valuations for the weaker end of investment-grade bonds have room to appreciate.
 Apple, Microsoft, Amazon, Alphabet (Google), and Facebook
 Conference Board Composite Index of Leading Economic Indicators. Economic variables include average weekly hours worked by manufacturing workers, initial unemployment claims, manufacturing new orders, building permits, steepness of the yield curve, among other variables.
 Michael Santolli, “Investors could be overplaying the election as a lasting driver of the stock market, history shows.” September 19, 2020.