Altair Insight: A Reset and a Recovery (4Q20) – Quarterly Market Review
Moving past 2020 feels like an accomplishment already in 2021. A year of unusual stress and tragedy, it left a wretched legacy: worst worldwide pandemic in a century, steepest economic downturn since the Great Depression, widespread racial strife, bitter election-year political divide. A survey of 28 historians deemed it the eighth-worst year in U.S. history.* The calendar has been reset – goodbye to 2020.
Last year’s urgent challenge has carried over: Complete a public health and economic recovery that both remain severely tested by COVID-19. But we see hopeful signs that much of this task can be completed by midyear with the distribution of vaccines.
Investors experienced a year of extremes, too, but with mostly positive outcomes. The swiftest bear-market plunge in history was followed by the fastest recovery and a new bull market that kept rising into 2021. The $8 trillion of liquidity added by global central banks to prop up their economies, coupled with trillions more in governments’ emergency relief programs, has helped to replace lost income and fuel stocks’ stunning comeback to all-time highs.
Forecasting the year ahead can be an exercise in futility, as last year’s dramatic series of unforeseen events reminded us. January already has been full of surprises, with Democrats effectively gaining a Senate majority and greater control of the government purse strings under President Joe Biden, not to mention the Capitol insurrection.
However, we are confident in predicting that 2021 overall will be a better year. Not necessarily for markets as it will be difficult to top last year’s unexpectedly strong performance, but rather a revitalization in both the U.S. and global economies as much of the world gets inoculated. Central banks and governments continue to backstop the recovery, offering further protection for markets.
Inoculating the Economy
Noah Kroese Illustration for Altair Advisers
Despite our generally positive outlook, the market’s surge to new highs and other factors restrain our optimism, and we are no longer overweighting stocks as we did last March after the historic pandemic-fueled sell-off. We recommend our clients remain at target allocation levels in all three risk categories: higher, medium and lower risk.
Further discussion of our thinking continues below as we look at the markets through the lens of five key themes:
1. The near-term outlook has weakened, but we expect a rapid return back toward normal growth to start by midyear.
We can see the light at the end of the tunnel for the pandemic and the Great Lockdown, as Federal Reserve Chair Jerome Powell first proclaimed after potent vaccines were unveiled last fall. But we expect it to dim for a while amid higher restrictions to try to contain the coronavirus’ holiday-induced spread – a weakening that may be accompanied by higher near-term market volatility.
The next several months are likely to be difficult. The labor market recovery has stalled, retail sales have declined for three straight months and small business optimism has fallen off sharply. Globally, the world faces a slow and challenging recovery that will be heavily reliant on the successful distribution of vaccines, according to the World Bank’s forecasters.
For now, the battle against COVID-19 is producing mixed results at best. The vaccine rollout has been plagued by supply issues, disorganization and a shortage of government resources. Infections have spiked in much of the United States and Europe as more contagious new variants of the virus take hold. The death toll has accelerated and now exceeds 400,000 in the U.S. and 2 million worldwide.
Despite the setbacks, we firmly believe this recovery is durable given that the economy is poised to benefit increasingly from two big tailwinds as the year proceeds: vaccinations and more fiscal stimulus.
Public health officials remain confident that a large percentage of the higher-risk population can be inoculated by midyear, helping to stunt the virus’ advance. By then the government’s latest fiscal stimulus package almost certainly will have been approved, sending as much as an additional $1.9 trillion into the economy to buttress last year’s stimulus. (More on that in section 2 below).
Increased distribution of vaccines should inject the slumping service economy with new vigor as people resume dining out, traveling and other long-idled activities. Manufacturing activity already has rebounded back to a two-year high. The online economy that prospered in a stay-at-home environment also is likely to expand further.
Consumers appear flush with cash and prepared for the economy’s reopening thanks to stimulus, increased savings efforts and the stock market’s gains. Household net worth rose by $5.2 trillion last year. The most recent personal savings rate was 13%, well above the historical average of 8.9%. The housing market is thriving due to heavy demand – home prices are soaring and new building permits also are rising.
Resurgent business activity also is appearing after a grim year that saw an estimated 4 million small businesses shutter. New business applications rose 24% over 2019 despite the pandemic, reflecting a surge in entrepreneurial activity in the second half of 2020. Corporate earnings are forecast by FactSet to rise 22% in 2021 after slumping badly last year.
With the recovery anticipated to accelerate, a majority of last year’s lost jobs are expected to be regained and growth in 2021 should put the economy back on its normal growth track.
Will all the government spending, coupled with revitalization of the global economy, produce higher inflation? Possibly, at some point in the future. But we do not see a meaningful increase on the horizon with unemployment still at 6.7% and massive stimulus meant to fill the huge economic gap created by the pandemic. Inflation is not easy to come by. In 2019 there was a perfect storm with unemployment at an all-time low of 3.5%, tariffs and solid monetary and fiscal stimulus, yet still inflation did not come. Powell has downplayed the risk, and current core inflation of around 1.4% is well below the Fed’s 2% target.
The mounting national debt is another matter to be addressed once the spending has helped to fully revive the economy.
In the midst of a global health crisis, we agree with the views espoused by Janet Yellen at her nomination hearing for Treasury secretary: “The long-term fiscal trajectory is a cause for concern. It’s something we will eventually need to attend to. But it is also important for America to invest.” The large investments envisioned, she said, will help prevent long-term scarring of the economy.
2. Fiscal stimulus should tide the economy over to its full reopening.
As with seemingly all construction projects, the cost of building a bridge over the vast gap in the U.S. economy created by months of lockdowns and 9.8 million lost jobs has exceeded estimates. The steep price notwithstanding, the latest fiscal commitments likely ensure its success as an emergency link back to a fully functioning economy later this year, presuming COVID-19 has receded.
The current tally is close to $7 trillion and counting in both fiscal ($3.5 trillion) and monetary stimulus. Democrats’ control of the presidency and both houses of Congress ensures the cost will run considerably higher, even if President Biden’s initial $1.9 trillion package is slashed.
As mentioned, we have concerns about the lasting consequences of this spending spree on the national debt, now close to $28 trillion and the equivalent of more than a year of GDP. But there was little practical alternative; without it, the recession would be deeper and longer-lasting. Consumers and small businesses are still struggling, even with the government’s help. Many state and local governments are in serious need of the assistance they expect to receive from the upcoming stimulus package.
The new power alignment in Washington should ensure that the money keeps flowing as long as the economy requires it. Janet Yellen’s nomination as Treasury secretary will give Biden a proven easy-money duo in the former Fed chair along with the current chair, Powell.
The Fed took the lead at the start of the crisis with its all-out support of the economy – slashing the federal funds rate by 1.5 percentage points, resuming massive purchases of Treasury bonds and mortgage-backed securities and taking further steps throughout the year. It pledged recently to continue holding rates near zero through 2023 and to maintain its bond-buying program until the economy reaches full employment and inflation stays at or even above 2%. It continues to inject approximately $120 billion into markets monthly through its purchases.
Yet recent weeks have marked an effective passing of the torch from monetary to fiscal support, first with the $900 billion emergency relief legislation signed into law on December 27th by President Donald Trump and now with the Biden stimulus package expected to soon gain approval in some form.
Investors have long adhered to a credo of “Don’t fight the Fed,” knowing that the stock market often takes its cues from monetary policy moves. With fiscal mega-support taking center stage for the economy in 2021, that can now be supplemented by “Don’t fight the government.”
3. Shifting trends are creating more balanced markets. Value and international stocks have become more attractive and will more fully participate in this year’s gains.
We believe stocks are well-positioned for further gains this year, even if a likely pullback at some point keeps them from matching their 2020 performance. More broadly based market strength means returns should come from different places, though, than just the growth/tech/U.S. areas that supercharged last year’s runup.
The market’s sunny outlook throughout a grim period of history has generated its fair share of skepticism. Some areas are indeed frothy, and we do not recommend overweighting higher-risk assets as we did last spring. But we see enough justification for the market’s ongoing optimism to retain our target weighting. High valuations notwithstanding, several sources of support should enable this 10-month-old bull market to endure short-term bouts of volatility:
- Friendly Fed: Under Jerome Powell or any near-term successor, the Federal Reserve is unlikely to waver from its pledge of all-out monetary policy support for the economy any time soon.
- Fiscal easing: The government’s response already dwarfs the $939 billion appropriated during the first year of the 2008-09 meltdown and is ongoing.
- Grand reopening: A resumption of a near-fully operational economy is expected by midyear or soon afterward as vaccinations expand, reviving service industries and nationwide employment.
- Pent-up demand: A vaccinated population will step up spending, reinvigorating the economy as business and leisure travel bounce back and shuttered restaurants and stores fully reopen.
- Resurgent earnings: S&P 500 companies are poised to end their streak of profit declines with double-digit percentage increases forecast for this year and next as the pandemic fades.
As the recovery evolves, we anticipate further changes away from trends that produced a lopsided market last year: The S&P 500 soared 70% from the March 23rd low thanks to a handful of tech-oriented giants that accounted for more than half of that gain, growth stocks trounced value stocks by the biggest margin in history, and U.S. stocks once again far outperformed their overseas peers. Those trends began to ebb in November and December as optimism for an end to the pandemic rose.
We think value and international stocks will participate more in markets’ advance this year, as they were deemed losers in the depths of a pandemic-fueled recession. As a result, we have been rebalancing client portfolios to adjust for growth’s unusually large share of the gains last year.
Still, we anticipate no sharp fall-off in growth and U.S. stocks but rather a more balanced market. The tech stocks whose valuations have soared are extremely profitable, in contrast to the ill-fated ascent of many in the dotcom bubble. U.S. stocks should benefit from a continuing tailwind from the factors cited above. Small caps and cyclical/value stocks, notably, have flourished since October as the economic outlook brightens and investors’ risk appetite returns. We retain our tactical overweight to both small- and large-cap U.S. stocks within the higher-risk category.
Value stocks, though, should gain momentum as vaccinations spread and earnings and growth rise. They historically show more strength in the first years of economic recoveries as sectors such as energy, financial services and industrials rebound. Their comparatively low valuations add to their potential.
International stocks narrowed the gap on their domestic peers in the fourth quarter on additional overseas stimulus and currencies’ gains against the dollar. We expect further improvement as Europe, particularly hard-hit by the pandemic last year, ends its lockdowns and begins to recover more rapidly. Lower valuations and the dollar’s continuing weakness should provide additional tailwinds.
Value and international share similarities that are driving both higher, too. Foreign developed markets are much more weighted toward value sectors without the dominance of technology that characterizes the U.S. market.
We do foresee a normal amount of volatility in 2021; it is common for the market to experience a decline of 10% to 15% within any given year. But we anticipate select opportunities and further gains as the government expands fiscal aid and consumers prepare to spend again when COVID-19 is brought under control.
4. Washington changes portend more spending and some tax increases, a near-term plus for markets with longer-term questions.
Having one party control both the White House and Congress for the first time in two years – first time in a decade for Democrats – removes some uncertainty for markets. It also greases the legislative skids for increased spending that might not have been possible in a split Congress.
Beyond that, though, the fact the Democrats will govern with the slimmest of Senate majorities after riding in on a “blue ripple” rather than a blue wave may mean a virtual Goldilocks scenario for investors: more fiscal support for a struggling economy but little ability to pass either a large tax increase or a big-ticket initiative deemed detrimental to markets. Democrats will hold their smallest House majority (11) in 140 years and narrowest Senate majority with a Democratic president (1) since 1884, constraining efforts at bold initiatives.
The Biden administration’s top priority for now is combating the COVID-19 pandemic. Without winning that battle and getting the economy back to normal, other programs will be in jeopardy. The new president’s initial coronavirus rescue package, discussed in #2 above, is expected to be followed by a second multitrillion-dollar initiative focused on infrastructure, climate change, health care and other priorities. That will be harder to enact, and the amount ultimately will be determined by the strength of the economy.
Biden intends to wrap some tax hikes into the new legislation to help pay for all the spending. Potential changes in 2021, according to Strategas Research, include raising the top marginal income tax rate to 39.6% from 37%, boosting the capital gains and dividend tax rate to 25%-28%, increasing the corporate tax rate to about 25% from 21% starting in 2022, raising the estate tax rate and cutting the estate tax exemption in half. Some tax increases may be retroactive.
It remains unclear how successful the Democrats will be at turning their initiatives into law with such narrow control of Congress. Also uncertain: the longer-term impact of such moves. Increased spending plus tax hikes would help growth in 2021 but could be drags on the economy in 2022 and 2023.
5. Geopolitical risks that were obscured by the virus and elections have not gone away, tempering our generally positive view of markets.
The tumult of 2020 pushed the pause button on some key concerns but did not erase them. Once the COVID-19 crisis and the U.S. transition turmoil have subsided, we are likely to find that these no-longer-hidden issues, and new ones, pose similar threats to markets’ stability in 2021.
China again figures into the biggest external concerns. It sprang back to strong growth in a surprisingly quick recovery from the pandemic – a plus for the global economy. But Beijing has amassed a growing number of adversaries over its aggressive stance on trade, intellectual property rights, human rights and territorial claims in the South China Sea.
U.S.-China tensions: The trade stand-off between the world’s two dominant economic powers appears headed in a less confrontational direction but hardly an end, with uncertainty high and Biden pledging no immediate change to the elevated tariffs imposed by the Trump administration. The phase-one trade deal signed by both countries in January 2020 left in place 25% tariffs on $250 billion worth of Chinese imports, which have hurt U.S. companies dependent on Chinese supply chains.
Trade issues aside, the new administration is likely to retain an aggressive stance if Beijing does not lessen what officials see as its intensive effort to steal intellectual property and conduct foreign influence operations in the United States. Biden has vowed to enlist other allies in a more unified global stand against China on all fronts, calling for pushing back on China’s “deepening authoritarianism” and its oppressive treatment of Hong Kong and Uighur Muslims.
It is not clear to us whether this leads to a new front in the Great Power competition between the two, or even a new cold war, as some experts we respect have predicted. But at least for this year we see no lessening of tensions, particularly with Chinese President Xi Jinping looking to further consolidate his power in advance of the Chinese Communist Party’s five-year congress in 2022, which will determine if he stays in power for a rare third term or is ousted. The potential for a dangerous escalation in U.S.-China diplomatic hostilities does not yet keep us up at night but is certainly possible. It would likely have major consequences.
China-Taiwan: As Xi reasserts his power, Taiwan becomes a likelier potential flashpoint. The U.S. surge in arms sales to Taiwan coupled with the two Asian countries’ growing antipathy toward each other has landed it atop the Eurasia Group’s list of the world’s biggest geopolitical risks in 2021. While a Chinese invasion in the near future is unlikely, the consultancy says that risk would grow if the Biden administration takes an ultra-aggressive approach toward China – for example, imposing a technology blockade.
Iran/Middle East: The geopolitical risk in this region, seemingly always present, has risen. Biden’s plan to reenter the nuclear deal that Trump withdrew from has drawn strong bipartisan opposition in Congress. That deal, agreed to in 2015 by several other world powers, placed significant restrictions on Iran’s nuclear program in exchange for the lifting of economic sanctions. Whether it is renewed or not, the fact that the U.S. and Iran moved briefly to the brink of war in January 2020 is a sobering reminder of what is at stake in any negotiations between the two sides. Any rapprochement between the two countries is certain to raise objections and tensions elsewhere in the Middle East. The collapse in global energy demand and prices left governments with weakened economies, heightening vulnerabilities in the region.
Russia: Already accused of interfering in the U.S. election system, American officials now have implicated the Kremlin in the hacking of more than 250 federal agencies and businesses, including many large corporations. A downturn in U.S.-Russian relations would likely make for more cyber trouble in 2021.
Success in efforts to subdue the coronavirus and reinvigorate growth are likely to lift the economy and markets this year. But a flare-up of any of the external risks cited above might jeopardize the recovery.
- The U.S. economic recovery has lost momentum but we believe it will endure the deadly COVID-19 surges that have prompted renewed closures and restrictions. The strength of housing and manufacturing help offset weakness in the job market and other areas.
- Widespread vaccinations, another round of fiscal stimulus and pent-up consumer and business demand should help fuel a return to normal economic activity levels in the second half of this year. The global economy should see a similar upswing as the pandemic’s impact lessens.
- We expect stocks to have another positive year, buoyed by ongoing monetary and fiscal support and on the back of solid earnings growth. But we do expect normal market volatility. A typical year sees at least one pullback of 10% to 15%.
- We retain our tactical overweights to U.S. small and large caps, which show continued strength. In addition, we anticipate that value and international stocks will perform well in a more balanced market.
- Interest rates are set to drift slightly higher but will likely remain range-bound this year. We do not view the slight increase in some inflation metrics as a threat as we do not think it will result in significantly higher inflation any time soon.
Quotes of the Quarter
“Right now, with interest rates at historic lows, the smartest thing we can do is act big.” – Janet Yellen, U.S. Treasury secretary, on the government push to prop up the coronavirus-scarred economy
“If history is any guide, unless there are substantial and effective reforms, the global economy is heading for a decade of disappointing growth outcomes.” – World Bank, Global Economic Prospects report
“Bitcoin is a highly speculative asset, which has conducted some funny business and some interesting and totally reprehensible money laundering activity.” – Christine Lagarde, European Central Bank president
The stock market ended an improbably strong 2020 at all-time highs, benefiting from all the stimulus poured into the economy along with vaccine progress that buoyed hopes for an end to the pandemic. Expectations for a second large coronavirus relief package from Congress, which arrived in the final days of the year, helped lift stocks to one of their best quarters in years.
The iShares S&P 500 ETF rode a 12.2% gain in the last three months to finish the year up 18.3%, the first time the index ended a year positive after being down more than 30%. Technology was the big sector winner for the year, rising 42%, with Apple, Amazon and Microsoft accounting for 53% of the index’s total return. Energy, the year’s clear loser with a 37% loss reflecting the plunge in demand and oil prices, led the way (+28%) in the final three months ahead of financials, industrials, materials, communications services and tech also with double-digit increases.
Small caps roared back from being down 39% at the March low to finishing as the year’s top asset class. The iShares Russell 2000 Index ETF had a best-ever 31.3% rise in the fourth quarter as investors’ faith in the economy’s comeback grew, ending the year with a 20.0% return.
The growth style of investing walloped value at all market capitalization levels in 2020. Among large caps, the iShares Russell 1000 Growth ETF registered an unprecedented full-year gap over its value peer, 38.2% to 2.7%. Yet the dominance halted at least temporarily from October through December, with value outpacing growth by 16.3% to 11.4%.
Both international developed and emerging-markets stocks outdid U.S. stocks in the closing months of 2020 to lead global stocks to their strongest fourth-quarter performance in 17 years (+14.4% for the MSCI All-World index). Stimulus from overseas central banks and governments, currencies’ strength against the weakening U.S. dollar and a December deal on Brexit between Britain and the European Union all contributed.
The iShares MSCI EAFE ETF, which tracks the performance of stocks in developed markets outside the United States and Canada, surged 15.7% from October through December after lagging for the prior nine months amid weakness in France, Japan and Britain. The international benchmark finished 7.6% higher for 2020. The dollar tumbled further as investors expanded into stocks outside their U.S. comfort zone with encouraging news about vaccines and the global recovery. Its decline of 4% in the fourth quarter and 12.5% from its three-year high last March made a significant difference for overseas stocks; conversion to the greenback added 4.3 percentage points to the EAFE index for the quarter and 6.3 percentage points for the year.
Emerging markets were lifted by big gains in China, which recovered swiftly from the pandemic, along with South Korea and Taiwan. The iShares MSCI Emerging Markets ETF rose 18.4% to post a 17.0% gain for the year. South Korea’s market led the way with a 43% increase in 2020, while China rose 27%. Brazil (-21%) and UK (-13%) markets were big losers.
Stay-at-home restrictions were bad news for investments in real estate investment trusts in 2020. Even with substantial gains in the fourth quarter as the outlook for vaccine rollouts and economic reopenings improved, both U.S. and international REITs endured negative years – the sole major asset class to finish in the red for the year.
U.S. REITs as gauged by the Vanguard REIT Index Fund ended 4.7% lower for the year after a final-quarter gain of 9.3%. Retail and lodging were among the hardest-hit REIT sectors in the pandemic, though both joined the late-year rally on anticipation for improvements in 2021. Overseas, global REITs as tracked by the Vanguard Global ex-US Real Estate ETF fell 6.9% in 2020 despite a 12.6% advance from October through December.
Hedged and opportunistic strategies had their best quarter of the year, lifted by stocks’ ascent. The HFRX Global Index, a benchmark tracking the universe of hedge-fund strategies, gained 5.1% to post a 6.8% return for 2020. That was its second-best annual return since 2009, trailing only last year’s 8.6%.
Corporate defaults rose swiftly in the second and third quarters of 2020, with over-levered businesses suffering from a lack of activity. Declines in the fourth quarter reflected tightening credit spreads, ability to refinance and roll loans, and forbearance extended to borrowers.
Closed-end fund discounts narrowed by 2.3% over the quarter, bringing the universe discount to -6.4% vs the long-term average of -5%.
Taxable and tax-exempt bonds were far outpaced by stocks in the fourth quarter after leading them through three quarters. Treasurys saw only a modest advance after the March 23rd low as the 10-year Treasury yield lingered below 1% for months, ending 2020 at 0.9%. Their performance during the turbulent early months of the pandemic, however, underscored their value as a portfolio diversifier.
The Vanguard Total Bond market ETF edged up 0.8% in the fourth quarter to increase its full-year return to 7.7%. Municipal bonds narrowly outperformed Treasurys for the third consecutive quarter since declining last March due to temporary illiquidity during the market plunge. Altair’s municipal bond benchmark, a blend of the Market Vectors short and intermediate ETFs, rose 1.1% to finish 2020 up 4.4%.
The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.