2021 Financial Outlook

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Introduction
“As stock market indices set historic highs despite the crippled economy, some have questioned whether investors are overlooking short term risks, which could spiral into longer term setbacks to the recovery. From an earnings perspective, it surely appears that valuations have gotten a bit out of hand.”

The defining story of 2020 is, of course, the COVID-19 pandemic, which proved to be a global test of healthcare infrastructure, central bank powers, and societal adjustments, among other things. No one was prepared for the complete economic shutdown or the death toll that continues to mount. Surging infections forced attempts from governments across the globe to limit the viral spread via business closures and quarantine restrictions, while offering monetary aid to citizens and affected industries. Shutdown results have been mixed, with the US response arguably among the most ineffective, if measured in terms of lives lost and financial carnage to households and small businesses. Historians will spend years analyzing why the US, despite its massive wealth advantage, struggled to contain the virus. Assuredly, there are multiple factors at play – poor leadership from partisan lawmakers seeking to leverage the pandemic during an election year, massive amounts of misinformation spread either ignorantly or maliciously via social media, and limited social safety nets in terms of unemployment protections and preventative health care, the latter of which may explain the mortality rate disparity between the US and its peers.

It is a bit callous to talk of “winners” during a pandemic that has claimed over 1.7 million lives worldwide, but for many large US corporations, COVID-19 resulted in accelerated earnings and greater market share. The mandated economic shutdown effectively destroyed smaller upstarts in industries deemed non-essential, while allowing the mega-cap behemoths (Wal-Mart, Amazon, etc.) to further expand market share. The shutdowns accelerated trends that have been growing for some time – online shopping, cloud computing, and virtual workplaces – and companies with exposure to these themes have seen share prices surge. Meanwhile, the Fed had opened the monetary floodgates – assuaging liquidity fears with several programs, including un-targeted payments to individuals, outright purchases of corporate debt, and facilitating cheap and potentially-forgivable loans to Main Street businesses. Thus, the “V-Shaped” stock market recovery was underway as remaining small businesses invested in pandemic-proof technology while citizens, with nowhere to go and a record savings rate, piled into mega-cap stocks with accelerated growth despite historically elevated valuations.

Presently, the year may be ending, but the pandemic story is not. The vaccine rollout has commenced, but it will take some time to get the targeted 70% of the populace vaccinated to achieve herd immunity, and the risk of a vaccine-resistant mutation to the current virus is unknown. The pandemic has brought about a profound shift across the globe, changing how we shop, how we work, and how we spend our leisure time. While we will get back to “normal” in many facets of life, there will be permanent changes in others. Considering these changes, taking the time to reevaluate our investment assumptions becomes more important than ever, which we shall do in the following 2021 Outlook.

Economic Backdrop

In recent years, The Federal Open Market Committee (FOMC) rate cuts and hikes have been responsible for market volatility; however, the current Federal Reserve (“the Fed”) administration has done a better job at communicating policy decisions in advance, aside from the emergency measures initiated during the pandemic. We anticipate this transparency and coordination will continue with the incoming administration’s selection of Janet Yellen as Treasury Secretary, as she shares many views with her Fed Chairman successor, current Chair Jerome Powell.

The Fed was aggressive in deploying the tools at its disposal, by increasing asset purchases to levels that dwarfed the 2008 financial crisis. The balance sheet expansion has reached over $7 trillion dollars and is unlikely to reverse, although the Fed has largely kept asset purchases confined to Treasury securities and mortgage-backed securities (MBS), rather than the corporate bonds (including high yield) that it pledged to buy during the height of the pandemic volatility.

Federal Reserve

Exhibit 1. Total Assets of the US Federal Reserve (in trillions of dollars) Source: www.federalreserve.gov.

The pandemic swiftly reversed 12 years of interest rate hikes, bringing the benchmark Federal Funds rate down to 0-0.25% for the first time since 2008. The Federal Open Market Committee lopped 50 basis points off in the first week of March, followed by a full 1% cut on March 16th. Despite speculation to the contrary, the Fed was ultimately able to keep rates above zero, while many foreign central bank peers took their lending rates deeper into negative territory. The Fed has since guided that they will keep rates where they are, near zero, through 2022 to avoid past communication missteps and market disruption. Signs of inflation are starting to show, most notably appearing in housing prices; but considering the high levels of unemployment stemming from the pandemic, we believe broad inflation will likely be held in check for the near term, though begin to approach the Fed’s 2% target if the virus is soon controlled. Furthermore, the Fed in its improved communication has indicated that a rise of inflation above 2% will not necessitate a rate hike and that modest overshoots are welcome in order to help offset prior misses.

The unemployment rate change during the pandemic created some jaw-dropping charts, as millions of Americans were laid off in unison. While some low wage earners got a payroll boost thanks to the additional $600/week unemployment benefits, the overall impact was devastating to many American households and small businesses, particularly restaurants and brick-and-mortar retailers. Some jobs have come back, but it will take years to reverse the damage and further aid will likely be needed for hard-hit industries such as restaurants and travel.

The massive COVID-19 shutdown caused unprecedented volatility on most measures of economic data, most notably in US GDP, which plunged -31.4% in the second quarter and then rebounded 33.1% in the third. Median forecasts for the final quarter of 2020 are right around 4%, but there is a high margin for error given the possibility of further restrictions and shutdowns in large portions of the country.

Unemployment Rate

Exhibit 2. Civilian Unemployment Rate, Seasonally Adjusted – November 2018 to November 2020 (highlighted areas indicate recessions). Source: Bureau of Labor Statistics.

US Equity

Growth stocks, particularly in the technology sector, have benefited tremendously from the shift to e-commerce and work-from-home. These stocks continue to perform well, but have cooled off slightly after reaching lofty valuations, as many investors have rebalanced back into the decimated value-oriented sectors. From June 30 through December 22nd, the best performing sectors have been the Industrials and Materials sectors, both up around 29%. Financials were close behind with a 25% gain and could run further in the near-term as the Fed recently announced all major banks have passed stress tests, clearing the way for returning capital to shareholders via dividends or share buybacks.

As stock market indices set historic highs despite the crippled economy, some have questioned whether investors are overlooking short term risks, which could spiral into longer term setbacks to the recovery. From an earnings perspective, it surely appears that valuations have gotten a bit out of hand. The inflation-adjusted Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE) shows equity valuations at levels only exceeded by the dot-com bubble.

Shiller CAPE Ratio

Exhibit 3. Shiller CAPE Ratio. Source: www.econ.yale.edu.

Surely such a lofty valuation cannot be sustained, can it? Before jettisoning equity exposure in preparation for an imminent crash, we should consider the context of the current market environment. Tech stocks inherently possess higher-than-average PE ratios, as many of these companies are engaged in cutting-edge products and services, and investors are buying potential future earnings more so than current earnings or dividends. As we have observed, the Technology sector has grown to comprise nearly 1/3 of the S&P 500 market cap, almost where it stood in 2000. While this may seem like an alarming parallel, we should note that today’s technology giants are far more established than the speculative names that crashed in the dot-com bubble. There is a strong argument that the Tech sector should be even larger, as more than half of Amazon (AMZN) profits stem from the e-commerce giant’s web services division, despite its classification as a Consumer Discretionary stock. As COVID has accelerated many of the technological shifts that were already in motion, the P/E of US equities may be more understandable and acceptable.

Low bond yields are also used to justify higher valuations for equities due to the dynamics of discounting, and with the Fed committed to keeping rates low, the downside valuation risk is lessened. Also, the lack of viable fixed income alternatives is a reason for maintaining equity exposure and reduces the opportunity costs of the income streams. Bond yields have been driven down to levels that have pushed investors into riskier corporate debt or out of bonds entirely and into equities. The massive wealth of the baby boomer generation will potentially need equities more so than shifting into bonds as retirees are living longer and need to take more risk with their long-term investments to stretch their retirement savings further.

Despite the COVID-related risks in the near term for 2021, in many ways the outlook for US equities has cleared up significantly. The election risks are over, and we can expect the Biden administration to take a significantly less bellicose approach towards China and other trade partners. This will alleviate one of the biggest sources of uncertainty from the prior administration. We also anticipate the new administration will avoid rocking the boat regarding the Trump corporate tax cuts, maintaining the status quo for at least until the pandemic is contained.

Developed International Equity

As one would expect, European nations aggressively countered the COVID shutdown with direct payments to businesses and citizens. The wealthier countries have covered 75-90% of wages for workers for the duration of the pandemic, with the Netherlands providing payments as high as $10,780 per month. Japan has also thrown tremendous amounts of stimulus at the virus, covering 100% of furloughed workers’ wages. Thus far, the relief measures seem to have stabilized economic output in the Eurozone, with manufacturing recovering a bit to make up for significant losses from the service sector. As of November, Eurozone Purchasing Manger Index data sat at 49.8, just below expansionary territory. With service-oriented business accounting for roughly 75% of GDP in the European Union, a full recovery will be unattainable until widespread vaccinations are available.

For a country known for its large population of elderly and vulnerable citizens, Japan has fared remarkably well in combating the virus, with under 3,000 deaths as of December 23rd. The low death toll is even more impressive considering the Japanese government never implemented mandatory lockdowns or business closures. Rather, the government merely suggested precautionary measures, which were widely followed. Widespread adherence to mask guidelines and aggressive contact tracing were also key to Japan’s success in containing the virus.

Developed International Equity stocks, which tend to be more value and dividend oriented than US indices, started to display relative strength in the final quarter of 2020. From 9/30/20 through 12/22/20, the MSCI EAFE index gained roughly 13.5% vs roughly 10% for the S&P 500. Developed International Equities began the year lagging their US counterparts, and at a relatively modest 17.4x next year’s earnings, there is still more ground to be made up in 2021 if the Eurozone can avoid a second lockdown. With hot spots popping up already, this could be unavoidable for some nations. Ultimately, for patient investors, maintaining exposure to Developed International Equity markets is recommended and will likely be rewarded once we weather this second wave.

Emerging Market Equity

As the source and epicenter of the initial COVID-19 outbreak, China has benefited from a perverse “first-mover” advantage, getting a head start on battling the virus. While the dubious nature of state-run media makes it near impossible to accurately measure the true cost of lives, it does seem that China has reached a relative level of containment as of year-end. While the pandemic drew the ire of President Trump, the global preoccupation with combatting the disease also stalled the escalating tariff war, which has faded to background noise amidst the bigger issue of a worldwide health crisis.

Chinese equities have jumped over 20% this year and look poised to continue outperforming as the country is set up for one of the fastest economic recoveries for 2021. Economic forecasts suggest 2021 Chinese GDP growth should exceed 9%, which would be the best growth rate in a decade. President Trump’s election defeat provides a much more predictable and amiable trade partner in President-elect Biden, removing some risks. China will likely significantly outperform its Emerging Market peers, many of which rely on energy production, which likely has limited upside after oil’s recent price recovery. It had been a rough few years for Emerging Market investors, as the promises of growth have failed to fully materialize as US stocks vastly outperformed. Despite this recent disappointment, the case for maintaining a foundational strategic weighting in Emerging Markets remains, and with a new US administration and a modest 14.9 forward P/E ratio for the MSCI Emerging Markets Index, the stars may finally be aligning for 2021 and beyond. The H2 2020 weak US Dollar has also helped EM stock prices and Dollar weakness is expected to remain.

Fixed Income

Risk-on sentiment in the second half of 2020 has pushed investors out of Treasuries and into corporate bonds, particularly those of the high yield variety. The unprecedented expansion of the Fed balance sheet into corporate bonds, including high yield, was the catalyst for an upward trend that has allowed corporate bonds to recover and post gains for the year. Investment grade corporate bonds have posted returns in excess of 10% for the year, while high yield is up roughly 3.5%, year-to-date through December 22nd. Long-term Treasuries were up over 27% for the year in August but have given back some of those gains and presently are up over 18%, still a considerable return considering most investors thought the long bond was out of runway prior to COVID.

Interestingly, all the Fed had to do to save the corporate bond market was announce a willingness to hold the debt, as the most significant gains occurred around the announcement, and the Fed ended up holding an insignificant amount of corporate debt on its balance sheet. Just knowing that the Fed would step in and bail out corporations was enough to crack open a geyser of liquidity, triggering a surge of corporate debt issuance and refinancing.

(SIFMA)

Exhibit 4. YTD through Q3, Total US Fixed Income Issuance. Source: Securities Industry and Financial Markets Association (SIFMA).

Short term, this has staved off a marked increase in defaults and investors should be able to squeeze the lemon at least a little while longer. There is a high range of uncertainty, however. Standard & Poor’s research suggests that by Q3 of 2021, high yield corporate bond default rates could be as low as 3.5% or as high as 12%, depending on whether businesses are able to re-open and the economy recovers. Investors should remain agile when allocating to high yield and we will be ready to shift into higher-quality debt if we see increased restrictions on businesses.

Commodities and Alternatives

Commodities saw demand drop off a cliff as manufacturing ground to a halt and supply chain disruption spread across the globe. Oil has stabilized after famously dipping into negative territory for some contracts but has hit a wall just under $50 per barrel. Crude demand has been seriously hampered by travel restrictions and fewer commuters due to remote work. An easing in lockdowns and travel bans could push oil above the current resistance but moderating self-imposed production cuts from OPEC means we likely will not see oil challenging $60 per barrel anytime soon. We continue to believe the risk to oil is downside, as demand has contracted and probably increases little.

Safe-haven commodities surged mid-year, with Gold prices briefly eclipsing $2,000/oz in August as investors sought to hedge against the unfathomable amount of money being printed by global central banks. Since then, demand has dropped off steadily, retesting support around $1,800 and looking range-bound while investors remain in “risk-on” mode. The other story affecting gold demand is the rise of cryptocurrencies and ascension from the fringes of the investment world to acceptance from notable investors and major global institutions. These extremely volatile investments are not for the faint of heart, but no doubt Bitcoin’s 2020 return of over 200% has enticed some gold bugs to diversify into “digital gold”.

The impact of COVID on real estate has been a fascinating story. On one hand, suburban residential real estate is booming, with work-from-home flexibility combining with ultra-low rates and limited supply to boost demand into potential bubble territory. At the same time, commercial office space is looking like a relic of the past, as companies realize they can function seamlessly without the real estate overhead. This is not a new phenomenon for retail real estate, though COVID has seemingly accelerated the death of brick-and-mortar shopping. With real estate sub-sectors taking such divergent paths, the best approach remains a nuanced one, separating the winners from the losers and allocating to growth areas – datacenters, 5G cellular infrastructure, and long-term assisted living, to name a few.

Final Thoughts

Closing the books on 2020 is, in many ways, cathartic; but one should keep in mind that year-ends are simply calendar markers, and COVID will not magically disappear on December 31 at the stroke of midnight. The downside risks remain high despite the clarity and insight we now have relative to those first few months of the pandemic. As always, we need to remain vigilant to the risks, and accurately gauge our risk tolerance and investment time horizon to capitalize on the investment opportunities yet be mindful of the inevitable volatility as we continue this journey back to normalcy. We hope you stay safe and healthy in 2021 and look forward to helping you achieve your investment goals.

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