Q4 2020 Market Perspective & 2021 Outlook
Whether you are a new investor or have been investing for decades, the events of 2020 were undoubtedly stressful. For some, this discomfort lasted only a few days, yet it may remain with some of you today. Our mission at Altium has been and always will be, to provide you with the clarity, confidence and control that you need to make sound decisions that will have a lasting impact on you and your families. In speaking with you throughout the year and in our written communications, we have emphasized the importance of trusting in your plan and the rules established in your investment policy statement (IPS). As we enter a new year, with its own set of challenges, we reiterate this message to you today.
Despite a tremendous amount of volatility in 2020, major U.S. equity markets ended the year near all-time high prices. We can appreciate the uncertainty that this may cause for investors now looking out to 2021 and therefore we hope that our perspective will provide you with some clarity on the current state of events.
Investors ultimately want to know if our domestic economy will recover to or exceed pre-pandemic levels or if the recovery from COVID-19 will be slower than expected and therefore challenge the stock indexes to sustain current price levels. We believe that there are structural measures in place providing support to the stock market and that there is upside potential to current economic recovery expectations. Therefore, we continue to recommend that long-term investors adhere to their investment policy and avoid any desire to engage in market timing based on near-term concerns.
2020 YEAR END MARKET HIGHLIGHTS
The S&P 500 index experienced its fastest fall ever from record highs to Bear market territory in March, following the outbreak of COVID-19. The index then completed a record recovery to new highs on the heels of unprecedented stimulus packages. The S&P 500 rallied nearly 68% from its March 23rd low, ending the year up 18.4% on a total return basis.
The big 5 (Apple, Microsoft, Amazon, Alphabet, Facebook) led the initial recovery of the S&P 500 and the recovery then broadened out to more cyclical companies during the last few months of the year driving the index even higher. At the end of August, the Big 5 stocks comprised 24% of the S&P 500 index, which has since declined to roughly 20.8% as of 1/20/21.
International and emerging market stocks also recovered from their respective lows. The emerging market index significantly outperformed its developed market counterpart while keeping pace with the large cap US stock index.
Fixed Income assets continue to provide stability and portfolio protection, despite the low interest rate environment (refer to Chart A in the Appendix). Depending on the amount of duration in your fixed income portfolio, bonds also provided appreciation during the year.
SUSTAINING THE MARKET RECOVERY: 3 IMPORTANT VARIABLES
The market first began its recovery in late March, following a massive stimulus package announced by the Federal Reserve, under the premise that the economy would return to pre-pandemic levels at some point once the global economy reopened. At that point in time it was less about the shape of the recovery (L, U, W, V, etc.) and more about looking past the pending recession. However, we believe that investors can now find proof that the economic recovery is underway.
GDP growth, the generally accepted measurement of the size and health of the economy, we believe has the potential to exceed expectations driven by consumer spending and growing corporate profits. According to the Fed’s December FOMC meeting summary, the median projection for real GDP growth in 2021 is 4.2%.2 Unfortunately, it will take some time to get a significant read on 2021 GDP growth. Final Q1 data will be out at the end of June and an early read on Q2 GDP will be released at the end of July.
Throughout the year, however, we will receive important data related to consumer strength. The U.S. consumer has demonstrated resilience throughout this pandemic, which could be from a combination of pent up demand and high levels of excess savings entering the recession. We expect unemployment rates to continue to improve in 2021 (unemployment improved from 14.8% in April to 6.7% in December 2020)3, consistent with historical results coming out of a recession. Furthermore, with expected improvements in the labor market, such as wage growth and bringing workers back into the labor force, we could see consumer spending lead GDP growth above current expectations.
Additional Stimulus & Holding Back Inflation
Stimulus has been swift and aggressive. The ‘open checkbook’ approach from the Fed has provided unprecedented support to the equity and fixed income markets. The Fed funds targeted interest rate remains near 0% and the Fed has announced that it expects to maintain short term rates at these levels through 2022.
Trillions of dollars have been spent on small business loans, stimulus checks, unemployment benefits and asset purchases. Additional stimulus is expected to be put in place early on in 2021 and this should translate to a swift GDP recovery, potentially above pre-pandemic levels.
While additional stimulus has been largely positive for stocks, investors will be looking for any signs that inflation is pacing ahead of expectations, which could be negative for the broad stock market. The goal of stimulus is to drive up demand, which can be inflationary if demand rises faster than the supply of goods and services. However, if we experience accelerating GDP growth and an improving labor market, this should help keep inflation at bay.
Additionally, the Fed has reiterated recently that it will tolerate inflation above its target rate for a sustained period of time before changing their extremely accommodative stance (i.e. raising short term interest rates or stopping the aggressive purchasing of various fixed income instruments). Low rates are positive for the economy, whether it's driving corporate spending or boosting the housing market, and maintaining low rates should continue to provide support to the stock market.
Defeating COVID-19 and Rebuilding the Economy
Reopening the full economy, while providing a safe environment for all Americans, will remain a challenge until we defeat this pandemic. The American people and the world have suffered tremendous loss during this pandemic and we have not lost sight of the impact this has had on many families and businesses. We do believe, however, that there is light at the end of the tunnel and progress will continue to be made every day. We will all be closely monitoring the vaccine rollout and other measures necessary for controlling COVID-19.
TRANSITION OF POLITICAL POWER
Shift of Power to Democratic Party Control
In addition to the inauguration of Joe Biden as President of the United States this past week the Democratic Party also holds a single digit margin in the House of Representatives and a tie-breaker vote in the Senate, through Vice President Harris. While control of the executive and legislative branches of government has undoubtedly shifted to the Democratic Party, with the slim Democratic margin many political experts anticipate that policy will be pushed towards the center of party lines.
Policy Agenda - Anticipate Scaled Back Tax Plans, But Taxes Go Up
It remains to be seen if the Democrats will attempt to introduce massive policy changes that have a lower chance of being passed or if they propose more moderate policy changes over the next couple of years. We expect to see a more scaled back agenda, relative to the full agenda that Biden campaigned on, including individual and corporate tax changes.
Corporate taxes are most likely first on the agenda (whether in 2021 or 2022), assuming that policy makers will want to see how the economic recovery shakes out before pushing for more substantial tax changes for individuals. However, we do expect that taxes go up. In addition to an increase in the top individual tax rate, the Biden plan also includes capping deductions, increasing capital gains rates and changes to Estate taxes. These potential changes will impact individuals differently and will be introduced at different periods of time. Any tax changes should be discussed with your tax professional and advisor.
EQUITY AND FIXED INCOME MARKETS OUTLOOK
Stock Market Volatility and More Modest Return Expectations
Volatility in the equity markets returned dramatically in 2020, back to levels last experienced in 2008. For reference, in 2020 the S&P 500 index experienced a daily move of more than 4% during 17 trading days, compared to only a combined 10 occurrences over the previous 10 years. (during the market correction in 2008 this level of volatility occurred 28 times)4 We expect volatility to normalize in 2021, but when stock prices are at all-time highs and valuations are at historically high levels, outsized market moves should be expected.
We looked back to 1928 (see chart B in Appendix) to offer some context around market volatility. Out of 92 one-year periods, the S&P 500 index was positive nearly 67% of the time, however, in just those positive years the index experienced a drawdown of 15% on average. We oftentimes need a reminder that market volatility is part of investing in risk assets and we reiterate the importance of maintaining a diversified portfolio that is managed in accordance with your investment policy.
We believe that the broad equity market has a level of support to it, driven mostly by the massive amount of stimulus and the low interest rate environment. Additionally, structural changes to the market have been developing that continue to drive up demand for stocks (including passive investing of savings into the market by many workers and increased access to the market via trading platforms).
Historically, stock valuations are “expensive”, but if we believe that an earnings recovery is underway we should begin to see valuations begin to normalize. In short, we are not concerned about being invested in the market at all-time highs as historically new highs can continue to be made over long periods of time. Interest Rates and Outlook for Fixed Income
In response to the economic slowdown, the Federal Reserve kept interest rates low in 2020 while simultaneously expanding their balance sheet with large asset purchase programs and lending facilities to support the fixed income markets. The Fed pledged in mid-December to continue with these asset purchases until they see progress toward maximum employment and price stability. During the 4th quarter, we did see the yield curve steepen as rates on the long end of the curve moved higher. This risk-on sentiment was the result of the start of COVID vaccinations and how that could spur economic growth along with anticipation of another stimulus package. Progress on the vaccination program will help shape the yield curve in 2021 and we expect short and intermediate yields to remain pegged near zero, while we should continue to see longer term yields continue to rise.
As we manage fixed income portfolios in this environment, we continue to balance income needs with downside protection. One method for managing risk is to focus on buying higher credit quality bonds in our corporate and municipal bond strategies. With interest rates still near historic low levels, we will also manage the duration of portfolios to dampen the effects of rate increases in the future. As our expectations for interest rates and inflation change we will continue to adjust where necessary.
The pandemic-induced recession of 2020 has not been officially declared over, however, it is likely that this past recession will be one of the shortest in history. Of course, we are not suggesting that an academic study of economic cycles is the same as defining the real-life impact that current events have had on individuals around the globe. There are many, long-lasting issues that need to be addressed and it will take a tremendous amount of effort and desire to restore balance. As it relates to the equity markets, however, economists believe that we are in the early stages of a new economic expansionary period which has historically been positive for the broad market.
We have repeated this message many times, however, 2020 has served as the perfect reminder of the importance of adhering to a rules-based investment policy. Short-term dislocations in the market are accounted for in your overall plan design and should not cause you to deviate from your investment policy.
We are grateful for the many conversations had with all of you throughout the year, whether simply revisiting a plan or adapting to changes in your personal situations. We are also proud of the results our team achieved in 2020, relating to the active oversight of portfolio rebalancing and tax loss harvesting, which we believe added tremendous value over the past 12 months.
Gregory Slater, CFA, CFP®, CIPM®
Chief Investment Officer
1 - Source: Bloomberg: S&P 500 Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index
2 - https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20201216.htm
3 - https://tradingeconomics.com/united-states/unemployment-rate
4 - Source: Bloomberg: S&P 500 Index historical returns. Daily % moves based on open, closing, high & low prices
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