The rebound in the US economy has continued into the final quarter of 2020, albeit at a slower pace, as geographic and industry-specific dislocations are exacerbated by varying problems associated with the ongoing COVID19 pandemic. Broad distribution of different vaccines has begun to provide a light at the end of the tunnel but rising cases and renewed lockdowns are moderating expectations of a resumption of pre-pandemic growth trend. Consensus expectations for real, or inflation-adjusted, gross domestic product (GDP) growth for the 4th quarter are varied within the low-to-mid single-digit percent range, though the most recent Atlanta Federal Reserve (Fed) GDPNow estimate is higher, at 10.4%.
Congress finally agreed to another round of fiscal relief in late December, though the non-targeted nature of direct cash payments along with industry-specific uncertainty are contributing to a so-called “K-shaped” recovery – an economic recovery in which certain industries are recording a banner year while others struggle as a going concern. The US employment situation has highlighted the dual-speed recovery, with the Bureau of Labor Statistics recording new highs for personal disposable income and personal savings rate, while initial claims for unemployment continue at close to ¾ of a million people per week. The official unemployment rate has fallen quickly, however, tumbling from the spring high of 14.7% to 6.7%. That still-unfortunate figure is nearly double the pre-pandemic level and excludes the fall in labor force participation from the pre-pandemic 63.4% to the latest 61.5%. Enhanced federal unemployment benefits has likely softened the blow to the most vulnerable, though this sub-surface economic erosion threatens the historical socio-economic system and, thus, the liquidity fueled climb in broad asset prices.
The largest threat to this paradigm continues to be the threat of inflation, or the decline in purchasing power of the US dollar. US inflation measures remained subdued, below a 2% annualized rate, but the greenback has declined during the quarter versus the trade-weighted basket of international currencies due, at least in part, to continued easy money policies from the US Fed – including the net purchase of an eye-popping $120 billion of US Treasury and mortgage-backed securities every month. The inclination of other major central banks to fight every fire with a flood of liquidity has kept the dollar decline in check.
Major US equity indices were able to shrug off a 7.5-8% peak-to-trough drawdown in the back half of October to finish the 4th quarter with double-digit percentage gains. The drawdown came amid uncertainty around the highly contentious election and doubts about another round of pandemic relief. Interest rates were also steadily on the rise, starting to price in a rebound in the economy or inflation which, as a denominator in discounting equations, started to take some air out of the rich valuations from accelerated growth-oriented equities. The latest push to new all-time highs has been fueled by an improvement in market breadth, with a broader participation from the previously less liked value sectors such as financials, with a more modest valuation compared to historical standards and attractive dividend yields. Even the energy sector rebounded during the final two months of the year after the combination of expectations for global energy demand due to vaccine optimism and curbed supply from OPEC and stymied North American producers drove oil prices to nine-month highs. The Utilities sector underperformed during the 4th quarter, with lockdowns hurting energy demand and incurred rising costs related to the pandemic. The result of the presidential election also raises the probability of more regulations or need for capital expenditures related to a shift to more renewable or green energy.
Small-cap US equities enjoyed a spectacular come-back during the 4th quarter, with the Russell 2000 recording its best quarter ever after over two years of relative underperformance versus their large-cap peers. Central bank liquidity and investor appetite for moving out on the risk spectrum has lowered capital costs of debt financing, while stellar IPO performance has done the same for equity. Optimism for post-pandemic life has fueled the outperformance, which may continue as investors look for relative discounts after taking profits elsewhere.
International equity markets also seemed to benefit from a 4th quarter rebalancing, with broad emerging markets leading due to less-severe economic impact from the pandemic and ample global liquidity. The weak US dollar also had a hand in driving emerging market prices higher. The incoming US administration is also expected to take a less aggressive stance on China, which has stabilized the relatively high growth expectations in the region. International developed market equities, with higher earnings multiples than emerging markets but still modest when compared to the US, performed relatively well thanks to supportive monetary and fiscal measures despite renewed lockdowns in parts of Europe. Economic uncertainty surrounding a deal regarding Brexit mercifully ended near the end of the quarter, providing some clarity to cross-border business in northern Europe.
Major Equity Market 4th Quarter Performance
The US Treasury interest rate yield curve steadily steepened during the quarter, with long-term inflation expectations influencing higher long-term Treasury yields. The yield on the 10-Year US Treasury Note ended near 0.9%, after beginning the quarter below 0.7%. The climb put long term Treasury bond prices under pressure, reversing some of the outsized 2020 performance. Broad corporate bond indices were able to finish the 4th quarter with solid gains due to compression of risk premiums, with high yield corporate bonds benefitting even more. High yield bond spreads continue to tighten near all-time lows despite default rates rising to the highest level since the Great Financial Crisis, as the pandemic applied the final nail in coffin for several energy and consumer goods companies. The Fed liquidity backstop deserves credit for this paradigm, which has emboldened investors by preventing the crisis of confidence that would normally send participants headed for a crowded exit.
Alternative assets, such as commodities, had an interesting quarter due to the weakened US dollar and the rebound in growth expectations. Oil prices, as previously discussed, rose and stabilized back above many producers’ costs while copper prices, a leading indicator of global economic growth, increased by 24% during the 4th quarter. Pandemic-related production issues, low interest rates, and an undersupply of single-family homes in American suburbs led to a shortage and skyrocketing prices for raw lumber contracts. The historical hedge for the loss of fiat currency purchasing power, gold, was only slightly higher in the final quarter of 2020 after a solid year-to-date run due to a speculative break-out in another alternative asset, cryptocurrency.
Markets have seemingly become quite euphoric in the immediate term, pricing in a continued rebound for global growth while risks are perceived to have been mitigated by Fed intervention. This may eventually spell trouble in terms of a severe pull-back, but bubbles can take years before they burst, and it is unlikely that a pop is imminent without another exogenous, black-swan event. The improvement in breadth portends a healthier market, with broader participation from small-caps and emerging markets signaling a brighter future. Our mission remains to manage our clients’ portfolios with a disciplined and emotionless investment approach and continue to deliver on our relationship with you guided by our principles of Passion, Integrity, Vision, and Care.
Thank you for the opportunity to be of service and we hope that everyone stays healthy and positive in these trying times. Happy, Healthy, and Profitable New Year!
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