Market & Economic Outlook
Market Commentary - Q1 2021
Market Commentary – Q1 2021
The fourth quarter of 2020 capped a year of strong risk asset returns and culminated in significant political changes in Washington. Meanwhile, near zero interest rates left investors who were seeking income beyond inflation unsure where to turn. In this quarter’s Market Commentary, we discuss the current state of global markets and our outlook for the first quarter of 2021.
In keeping with the frenzied cadence of news flow in 2020, an eventful fourth quarter capped off a rollercoaster journey of a year that no one saw coming. A resurgence of COVID-19 cases in the U.S. and Europe was outshined by welcome news on vaccine approvals, a conclusion to the U.S. Presidential election, an additional round of fiscal stimulus and even a Brexit deal for good measure. Aside from the unfortunate spike in cases, the necessary ingredients for the global stock market to continue its monumental comeback were delivered as hoped. On balance, the good news also put upward pressure on longer-term interest rates as investors recalibrated for higher inflation and growth expectations. With the full year now in the history books, there are certainly many reasons why 2020 will not be associated with fond memories but, fortunately, full-year investment returns won’t be one of them.
Eagerly awaited vaccine approvals likely mark the beginning of the end of the pandemic. The light at the end of the COVID tunnel is shining as brightly as ever, allowing investors to further embrace a “glass half full” outlook despite the economy remaining far from fully recovered. A belief that modern medicine was up to the challenge of defeating the novel coronavirus, combined with unprecedented levels of globally coordinated monetary and fiscal support, has perpetuated optimistic sentiment in risk assets since the early days of the outbreak.
Not only have most global equity and credit markets fully recovered losses from the February/March downturn, but many managed to post strong positive returns for the year—an improbable feat given the economic challenges created by the severely constraining countermeasures implemented to combat the spread of the virus.
As the pendulum of investor risk appetite swung wildly from one end of the spectrum to the other amid the many economic disruptions in 2020, many questioned if the financial market recovery had come too far too fast. Using the S&P 500 Index as the posterchild for this dynamic, the measure of U.S. large cap stock performance fell 33 percent during the five-week period from February 19 through March 23. By mid-August the index had recovered the entirety of its earlier losses to finish the year at an all-time high with a total return (including dividends) of 18.4 percent. Such strong performance might seem counterintuitive considering earnings for companies in the S&P 500 were expected to decline by 13.6 percent in 2020, according to FactSet.
Yet, financial markets tend to overlook present conditions and focus on the future. In this regard, investors appear to be writing off 2020 as an aberration and see a bright future ahead, at least for corporate profits.
According to FactSet, analyst consensus estimates for 2021 S&P 500 earnings anticipate growth of over 22 percent—representing more than a full recovery back to 2019 levels.
Combine this forecast with ultra-low interest rates induced by central bank bond buying and you get the perfect recipe for equity price appreciation. Of course, both the expectation for corporate earnings to recover quickly and interest rates to remain low must be realized for the market’s recent price action to be justified. For this reason, it is important to remain mindful of the equity market’s vulnerability to “the curse of high expectations,” which is a risk that always accompanies premium valuations.
As we highlighted in the Q4 2020 Market Commentary, the rising tide of investor sentiment has not lifted all boats equally. A clear preference for “new economy” companies with the most open-ended earnings growth potential emerged, while so called “old economy” stocks with higher sensitivity to the economic cycle were left behind. Underscoring this disparity was the performance of the best and worst sectors within the S&P 500 Index. The Information Technology sector surged nearly 44 percent in 2020, while the Energy sector declined almost 34 percent. In light of such unprecedented circumstances, gravitation toward companies with at least partial immunity to the economic cycle is certainly not irrational, but is it overdone?
With the stimulus spigot firmly in the “on” position as the economy heals from the devastation of pandemic-related shutdowns and pent-up demand emerges, it creates the ideal conditions for a surge in growth that would likely benefit the most economically sensitive sectors. Many of these so-called “value” stocks are trading on low expectations in light of the uncertainty about the speed and strength of the global economic recovery. To that end, the International Monetary Fund (IMF) is forecasting global growth to rebound next year to 5.2 percent following an expected contraction of -4.4 percent in 2020. In its October World Economic Outlook, the IMF noted that “while the global economy is coming back, the ascent will likely be long, uneven, and uncertain,” adding “economies everywhere face difficult paths back to pre-pandemic activity levels.”
It is caveats like these that have investors understandably skeptical about the outlook for cyclically sensitive stocks. But as we look across sectors, valuations look compelling relative to their secular growth-oriented peers and one could make the argument that investors are reasonably well compensated for the inherent uncertainty. For this reason, we see a longer potential runway for equity asset classes that are more exposed to these sectors including domestic small cap stocks and non-U.S. equities heading into 2021.
Regardless of how quickly life normalizes in a post-pandemic environment, some aspects of commerce might have changed for good. Perhaps one of the most obvious long-term implications of the pandemic is the acceleration of longrunning technology trends. Advancements in technological enablement along with the disruption of in-person business activity have converged to challenge the way employers and consumers think about the need to engage their respective counterparts.
An explosion in working from home and online shopping, initially driven by temporary necessity at the onset of the pandemic, might not return to pre-pandemic levels any time soon, if ever. A permanent shift to more virtual commerce has real ramifications for office space and brick-and-mortar retail locations.
While online shopping trends merely accelerated what already looked inevitable, a more unexpected paradigm shift could have occurred in the workplace. Exactly how many workers will be returning to their offices either full- or part-time once the pandemic is behind us is an open question; but there is no doubt this forced experiment has created the opportunity for employers to evaluate their real estate needs and employees to demonstrate they can be productive without going into the office.
Anecdotally, corporate managers have already begun to telegraph their plans to conduct business differently going forward. In a recent shareholder letter,
Jefferies Financial Group executives noted,
“We learned that we all have much more flexibility than we ever realized in how, where and when we can work. The question therefore is: what does the future of work look like and how can we best design the operating environment of Jefferies to incorporate the needs and desires of our clients and our team? ... it is clear that there will be some version of a hybrid model going forward, creating a combination of a series of active central offices and meeting places, balanced with the opportunity to work from home.”
We expect to hear many comments like this in the coming months as companies plan for life after COVID. Green Street Advisors, a commercial real estate research firm, estimates demand for office space overall could fall between 10 and 15 percent with the adoption of remote work arrangements.
However, Green Street also notes that a potential reversal of the trend toward office densification (putting more workers in less space) could offset some of this lost demand. In any case, this will be an important issue to keep an eye on, not just for the office sector investment implications, but also for the knock-on impact to residential real estate markets in gateway cities as remote-working arrangements factor into where employees chose to reside.
Stable or declining inflation over the past few decades has helped to push interest rates lower across developed global markets. Aggressive, innovative, and enormous central bank interest rate and asset purchasing policies have driven global rates even lower in recent years. These policies seek to ease credit conditions during the global pandemic and maintain an economy on life support but have also boosted asset prices and pushed yields to near record lows across many global asset classes.
This financial repression, a result of policies that take rates lower than inflation, is causing investors, particularly those whose goals rely on income, to explore new investment strategies as a means to generate income in a low interest rate world. To evaluate these alternatives, investors should review their long-term goals and objectives and understand the risks and risk/return trade-offs of income generating alternatives. Within this trade-off, various risk parameters must be evaluated particularly as yield is only a component of an investment’s total return.
Former Federal Reserve Chairman Ben Bernanke best explains the theory and desired result of easy monetary policy through lower interest rates and quantitative easing, or central bank asset purchases, as follows:
“Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
Financial policies to create a “virtuous circle” also encourage income-reliant investors to invest further out on the risk/return spectrum to generate the same income today that they generated before. This is often referred to as “crowding out” savers from ultra-low risk assets such as money market funds or U.S. Treasuries. Some central banks in Europe and Asia have taken crowding out to an extreme through negative interest rate policies, creating the ultimate crowding out environment resulting in roughly $18 trillion worth of negative yielding financial assets globally.
The Fed’s new policy-making mandate (discussed in the Q4 2020 Market Commentary), combined with its recent central tendency forecast, equate to “lower for longer” short maturity interest rates. As such, the federal funds rate will likely hover near zero well into 2023.
Investors facing financial repression have alternatives (a few are reviewed below) to enhance income. However, there is no such thing as a “free lunch” or enhanced yield without additional risk. There might be acceptable risk/return trade-offs depending on individual financial objectives, goals and risk tolerances.
Short Duration Fixed Income: A diversified portfolio of investment grade corporate bonds, with typical maturities of three years or less, can offer roughly 25 to 75 basis points of additional income versus money market investments. This is dependent on portfolio parameters including duration, credit ratings, and sector allocation.
Relative to typical money market investments, short duration fixed income has modestly more interest rate risk (duration), credit risk, return variability and reduced liquidity, but benefits from increased issuer diversification. As short maturity U.S. Treasury rates are anchored by federal funds expectations, “lower for longer” policies should mean minimal short maturity interest rate risk in the near term. A modest increase in credit risk relative to money markets is commensurate with a short duration portfolio investing across the investment grade corporate bond rating spectrum. Given that the Fed has explicitly supported short duration investment grade bonds recently and, given what could be a protracted post-pandemic recovery, a modest increase in credit risk might be an acceptable trade-off.
Money market funds are often forced to have significant exposure to financial issuers, while the short duration fixed income opportunity set spans many industries and fixed income sectors. Liquidity, or the ability to sell a position, is slightly worse for short duration fixed income relative to money markets, as cash investments can typically be accessed with same-day liquidity while short duration can require a few days to generate substantial liquidity. Given global crowding out and investors’ hunt for yield, we do not expect liquidity risk to represent a significant concern anytime soon. Investors can expect, however, modestly increased price variability of a short duration fixed income portfolio relative to money market investments.
Intermediate Duration Fixed Income: A diversified portfolio of investment grade bonds, with average portfolio duration between three and seven years and maturities typically less than 10 years, can offer from 50 to 100 basis points of additional income above money markets depending on portfolio parameters.
Intermediate duration fixed income credit risk can be slightly higher than short duration fixed income portfolios due to the longer maturities of the individual bonds. Similarly, liquidity risk can be slightly higher given higher transaction costs when selling longer maturity securities. The largest risk factor increase for intermediate duration investments is a significantly larger amount of interest rate risk relative to money market investments and short duration fixed income.
Return variability is typically larger than both short duration fixed income and money market investments. Although we expect short maturity interest rates to remain relatively stable near term, intermediate maturity interest rates could drift higher, resulting in a potential decline in market value.
High Yield Fixed Income: A diversified portfolio of below investment grade high yield securities can offer 400 to 500 basis points of additional income over money markets. These portfolios typically exhibit modest to minimal interest rate sensitivity. However, credit risk is substantial as all of the investments are rated below investment grade and the underlying companies are typically less stable in terms of balance sheets than investment grade companies. Liquidity is moderate given higher transaction costs within high yield and return variability can be substantial.
Preferred Stock: A hybrid between traditional bonds and traditional equities, preferreds are securities that are more senior in the corporate capital structure than common equity, but lower than traditional debt, and often carry substantial dividends. Preferred stock from investment grade companies can offer 200 to 300 basis points of additional income above money markets. Duration tends to be modestly less than intermediate fixed income, while credit risk is greater than fixed income but less than traditional equity from the same issuer. As such, return volatility can be substantial, but typically less than traditional equities or high yield investments.
High Dividend Yield Equities: Income generation can also be enhanced through various high dividend yield strategies. While the S&P 500 has a dividend yield of 1.5 percent, exceeding the 0.93 percent yield of the 10-year U.S. Treasury, several focused equity indices have dividend yields exceeding that of the S&P 500 Index. The dividend yield on the MSCI USA High Dividend Yield Index exceeds 3 percent, the MSCI World High Dividend Yield Index exceeds 3.6 percent, the Dow Jones Utility Index exceeds 3.7 percent, the MSCI US REIT Index exceeds 4 percent, and the Alerian MLP Index exceeds 12 percent. This income generation potential, however, isn’t without various risks.
Liquidity in most equities beyond small capitalization names is relatively strong. However, the return variability of equities is significantly higher than fixed income securities due to increased credit risk, equities being lower in the corporate capital structure, and minimal industry diversification within focused strategies. Some focused strategies have enhanced sensitivity to interest rates, such as utilities and REITs, while other high dividend yielding stocks might be under pressure to cut dividends when dividends exceed free cash flow, such as midstream energy offerings or Master Limited Partnerships (MLPs).
For investors with longer-term investment horizons, however, high dividend yield equities can represent an interesting yield and expected return advantage versus much of the money market and fixed income world, albeit with significantly more return volatility along the way.
Financial repression and a low interest rate world are likely to persist for years. There are numerous investment strategies available that can be utilized to enhance income in a low yielding world. These strategies aren’t without varying degrees of risk. Understanding risk/return trade-offs is a necessity when evaluating income alternatives in a world of low yields.
National political attention shifted from the Presidential election in November to two run-offs in Georgia that effectively shifted the Senate into a 50/50 party split with Vice President-elect Kamala Harris in position as the tiebreaker.
With the Democratic Party having now taken over the Senate, albeit with a razorthin majority, changes in tax policy and regulatory oversight might well be on the table. The potential for more expansive pandemic relief measures could also lead to an uptick in inflation. But with 60 Senate votes required to override potential Republican filibusters and pass bills, attention will shift to how moderates from both parties will react to the measures brought forward by the new administration and Congress.
Meanwhile, President-elect Biden may approach working with his new colleagues on both the Republican and Democratic aisles in a bipartisan manner regardless of Senate control. Compared to both the current and former presidents, Biden appears to be open to compromises necessary to implement deals that, while appealing to neither the progressive wing of his own party or hard-line Republicans, reflect the type of old-school politics Biden has practiced since joining the Senate in 1973.
Further, the fact that the November “Blue Wave” failed to materialize and Republicans did well “down ticket” in both state houses and the House of Representatives, the ambitions of Democratic progressives facing re-election in upcoming mid-terms might be tempered as legislative moderation could help with their re-election. There are several areas where both parties have indicated common ground going into 2021.
One is increasing antitrust scrutiny of the tech sector and, mirroring aggressive moves by regulators in Europe, bolstering federal privacy laws. Section 230 of the Communications Decency Act, which includes a “safe harbor” from civil liabilities for on-line media platforms, also seems ripe for revision albeit from differing points of view across party lines. While revising Section 230 might open social media platforms to increased legal costs, in our opinion it will not be a major factor in the tech sector’s prospects for market gains in 2021 and beyond.
Health care is another area of potential compromise. The pandemic has brought home the risks inherent in offshoring the manufacture of both drug and personal protection equipment. Drug price controls, particularly for prescriptions most used by seniors, might also be on the table and the Affordable Care Act is likely to see modifications but is unlikely to be dramatically altered.
In addition, the incoming Biden administration has begun to lay the foundation for an infrastructure bill by speaking with corporate and union leaders who appear receptive to a 2021 bipartisan infrastructure package that could help the economy heal from the pandemic. While the scope of the potential infrastructure bill is unclear today, we are hopeful that elements beyond constructing roads and bridges, such as expanding access to broadband and 5G, are part of the final package.
The tone of trade relations with China should shift from the aggressive stance of the Trump administration, but the bulk of current trade policies are likely to remain in place as Biden’s team conducts a comprehensive review of trading relations with China. An early indicator of the new administration’s China policy will be its reaction to the December 30 European Union/China pact that eases restrictions on European companies operating in China. The Biden team might find itself torn between supporting the European allies Mr. Trump alienated and rejecting the deal over human rights issues in China.
One area of agreement across party lines is the need to tighten intellectual protections from forced transfer as the price of doing business in China. Mr. Trump’s hard-nosed approach has set off an ambitious plan by the Chinese government to be nearly self-sufficient in chip manufacturing by 2025 as the opportunity to extract expertise from U.S. firms dwindles.
As China attempts to onshore critical industries, the U.S. may follow suit to selfsource essential materials—such as rare earth minerals—used in a variety of products. While there would be vigorous debate about mining in the U.S., both parties would likely agree that removing resource-based bargaining chips held by China is a laudable goal.
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