January 22, 2021
Quarterly Market Commentary
Confounding many experts, economies and financial markets experienced V-shaped recoveries in 2020, but will this last into 2021?
Investors had to deal with a myriad of issues in 2020, any one of which would normally have dampened risk appetite. The global COVID-19 outbreak forced economies to shut down under stay-at-home orders, leading to a dramatic increase in unemployment in the U.S. and driving the global economy into recession. At the same time, investors had to grapple with a U.S. presidential election in an environment of rising social unrest.
The “power of policy,” however, was on full display, not only acting as a buffer to these challenging conditions but also creating a massive risk asset tailwind that drove global equities more than 16% higher. Indeed, the combination of aggressive global monetary policy and strong fiscal responses proved an effective offset to the immediate damage wrought by the pandemic.
Of course, these programs were intended to build a bridge to a real recovery, and it is now the development of an effective vaccine that lends confidence to the 2021 outlook discussed below.
Back on Stable Footing and Ready for Take-Off
Global economies continue to battle COVID-19, and strong second and third waves of the virus are taking a toll on the near-term outlook. As vaccine distribution programs improve, we see a much stronger second half of 2021.
The economic weakness around the world in 2020 was a direct result of mitigation measures designed to stop the spread of the pandemic — the very definition of an exogeneous shock. Recession was not the outcome of traditional economic pressures, nor was it driven by a change in monetary policy. Accordingly, the necessary remedy was also nontraditional and not economic in nature: a vaccine, or in this case, a series of effective vaccines.
As with most recessions, more traditional policy tools were implemented, effectively mitigating the downside while preventing some of the longer-lasting scars that can develop during recessions. Examples include persistently high unemployment, as workers become displaced and lose their competitiveness, and bankruptcies, which represent a permanent loss in capital and significant economic setback.
Avoiding such scars and supporting the economy through the rolling shut-downs and stay-at-home orders around the world was the work of policymakers. Central bankers embarked on aggressive policies to support markets and succeeded by lowering interest rates and expanding balance sheets. Fiscal authorities rolled up their own sleeves, and politicians were able to negotiate significant fiscal support to those in need. Remarkably, the European Union was able to forge a recovery fund — a balance of loans and grants to impacted countries — which effectively mutualizes the cost of a program designed to spur growth in the post COVID-19 environment. This was an unprecedented move for members of the EU. Although the fund is modestly sized, it provides the first step toward building an important framework for a potential fiscal union.
While Europe and the U.S. continue to lengthen and strengthen recovery bridges in anticipation of broad vaccine distribution and new, fast-spreading virus waves, there is one economy that was able to actually grow in 2020: China’s. The country was first to experience the crisis and has been the first to emerge from it, while avoiding steep economic losses.
Looking forward, we are optimistic that vaccine distribution will improve over the next several months and allow economies to reopen more confidently in the second half of 2021. Monetary policy support will remain, and fiscal support — with a focus on the services sector — should lead to significant growth, driven by consumers. This view is strengthened by high household savings resulting from fiscal support, which is likely to spark the tinder of pent-up demand.
- Avoiding deeper economic scars in 2020 was the work of policymakers; recovery in 2021 hinges on vaccine rollouts.
- We expect a much stronger second half of 2021, as vaccine distribution improves.
- Monetary support will remain, and fiscal support should help unleash pent-up consumer demand as the year progresses.
Source: Bloomberg as of December 31, 2020. Purchasing manager indexes (PMI) are economic indicators resulting from monthly surveys of private sector companies.
Anticipating the Bounce
In 2020, investors were reminded that equity markets are discounting mechanisms that focus on future — not current — conditions. While the environment for corporations was challenging and led to a worldwide earnings decline, investors were able to look beyond near-term challenges to a post COVID-19 bounce.
Consistent with our economic outlook, we see a powerful earnings rebound in 2021, with the best results coming from the sectors and regions hardest hit last year. Most notably, we anticipate strong rebounds in Europe, Japan and emerging markets given their relatively high exposure to cyclical sectors and sensitivity to global economic growth trends.
While the U.S. may lag, we continue to see opportunities in small capitalization indices and certain cyclical sectors. Again, these are areas that are more leveraged to economic recovery.
That said, we continue to preach diversification: Investors should avoid tilting to cyclical and small caps at the expense of some of the tried-and-true large cap growth stocks, which should also benefit, albeit likely to a lesser degree, from the rebound.
While fundamental earnings growth should be a tailwind, global equities also face an important headwind: valuations. Much of the improvement in the outlook is already reflected in stock prices, which, across the globe, appear historically elevated. Some price-to-earnings multiple expansion is a function of depressed earnings. However, even adjusted for forward expectations that incorporate recovery, we see expensive valuations.
Additional signs of investor enthusiasm for stocks also bear watching: an extremely active IPO market, options market data that shows elevated levels of retail trading, and speculation and individual investor sentiment indicators breaching high water marks, to name a few. This exuberance, coupled with high valuations, will likely suppress market returns in 2021 and beyond, as corporate fundamentals will need to meet high expectations and grow into elevated valuations.
Our expectation for global equity returns in 2021 falls in the mid-single digit range, with the highest returns anticipated in emerging markets and the lowest relative returns in the U.S., based on the U.S. having the highest valuations as a starting point.
A final lesson for investors, which was driven home in 2020, is the folly of market timing and the importance of staying invested even during times of stress.
- While fundamental earnings growth should be a tailwind, global equities also face an important headwind: valuations.
- Additional signs of investors exuberance bear watching.
- Our expectation for global equity returns in 2021 falls in the mid-single digit range, with the highest returns in emerging markets and the lowest relative returns in the U.S., based largely on relative valuations.
EARNINGS GROWTH REBOUND
Source: Northern Trust Asset Management, FactSet. *Consensus forecasts. Indices used: S&P 500 (U.S. equities); MSCI World ex-U.S. (developed ex-U.S. equities); MSCI EM (emerging market equities).
A Lower Resting Heart Rate
Our fixed income outlook is based on the high probability that global central banks will remain extremely accommodative through the COVID-19 economic recovery period — and likely beyond. Rock bottom interest rates and aggressive bond-buying driven by major central banks have collectively resulted in over $17 trillion in bonds currently offering negative yields. This represents over 25% of the word’s investment grade fixed income market.
For U.S. investors, although yields remain positive across Treasury and investment grade corporate bond markets, the absolute level of available yield is uninspiring, and in our view, will remain so for the next several years. Despite an expected post-pandemic growth surge, which may accompany a short-term inflation burst, we continue to believe that the resting heart rate of both growth and inflation will be lower, supporting our base case that rates will also remain low. While cyclical forces may win over the short run, driving above-potential growth in 2021 and likely into 2022, the longer-term structural headwinds of aging demographics and higher debt loads should ultimately prevail.
There is a risk to this outlook: inflation. However, our premise that inflation is more permanently “stuck” at a low level due to demographic and debt observations is strengthened further by technological trends. Technology allows us to do more with less, do more faster, and ultimately, do more at a lower cost. The pandemic has accelerated this trend and illuminated its benefits in stark relief. We expect this to continue.
We are beginning to see positive fundamental trends in the credit market, both in investment grade, including taxable and tax-exempt credits, and high yield. Much like the equity markets, however, the contraction we have seen in credit spreads already reflects these favorable trends. While robust economic recovery in 2021 is likely to justify these tighter spreads as default risk falls, coupons will likely be clipped with very little lift from further spread tightening going forward.
As always, but particularly as rates have fallen so dramatically, clients ask, “why should I own bonds right now?” The answer today, and always, is diversification. While there is not a lot of income in fixed income, we continue to see durable and reliable diversification benefits in short-duration high quality fixed income, and these assets are at the core of our clients’ Risk Control portfolios. Given our outlook for rates to remain constrained, we stress to investors the importance of ensuring cash and high-quality fixed income allocations are appropriately sized relative to goal funding and risk tolerance.
- We are beginning to see positive fundamental credit trends, but they are largely already reflected by tighter credit spreads.
- Economic recovery in 2021 will likely justify tight spreads, but additional spread tightening is unlikely to provide much of a lift to coupon clipping.
- Despite our expectation that uninspiring yields will likely persist, bonds remain an important part of diversified portfolios.
- Now is a good time to ensure cash and high-quality fixed income allocations are appropriately sized.
To summarize: Our outlook for the real economy is constructive, particularly as we head toward the latter half of 2021, under the important assumption that we reconcile some of the logistical challenges that have already emerged during vaccine rollouts around the world. We are similarly constructive on risk assets, recognizing, however, that asset prices already reflect much of the expected earnings rebound. Even so, we anticipate strong fundamentals will lift equities this year.
We also highlight inflation as the one key risk to our outlook. If inflation expectations rise too quickly, leading to a rapid rise in longer-term rates, we believe risk asset markets would be vulnerable to a correction. Investors would likely begin to pull forward the timeline for monetary policy normalization, believing the Fed may prematurely reduce quantitative easing or even start raising interest rates.
An additional risk to the U.S. financial markets may come from Washington D.C. As we sit at the earliest days of a new administration, we observe an ambitious agenda of spending that could possibly be coupled with an equally aggressive tax policy agenda. Fiscal spending at the levels being discussed, and financed with Treasury issuance, may be too much of a good thing for markets. The growth impulse would be strong, exacerbating investor concerns about inflation, and the supply of Treasuries in the absence of deeper engagement by the Fed may cause rates to rise. Further, the impact of potentially higher corporate taxes, increases in capital gains and dividend tax rates, and a change in estate tax policy could possibly change investor behavior — even over the short term — and drive market volatility.
While we believe that it will be difficult for the Biden administration with a slim majority to enact significant changes to tax policy, it is not a zero probability. Ultimately both investors and corporations acclimate to higher taxes, but the process can be volatile. Now is the time to assess your goals and the timelines for funding them, quantify your intergenerational wealth transfer goals and work with your advisors to ensure your current plan works even in a higher tax regime. It is always better to prepare than to predict. Now is the time to prepare.
U.S. GOVERNMENT FISCAL STATE
Source: Northern Trust Asset Management, Bloomberg, Federal Reserve, IMF, CBO. IMF = International Monetary Fund, forecast period 2020 through 2024. Debt to net worth data through 2019; household and nonprofit organization net worth. CBO=Congressional Budget Office, forecast period 2020 through 2030.