2020 has been a year defined by the first global pandemic in more than 100 years, unprecedented fiscal and monetary policy responses as well as one of the most contentious presidential elections in modern times. Despite being a year that most of us would like to forget, it will be exceedingly difficult for history to do the same. Global financial markets ended the year much like they began with equities in a bull market. It is hard to believe that markets recovered so quickly from lows set in March. Given that the U.S. economy is in the early stages of its recovery, many would have expected a different outcome. However, the collective power of massive federal stimulus, robust liquidity from the Federal Reserve and the rapid development of multiple COVID vaccines has allowed the market to see past the current issues at hand and to shift its focus toward a future of normalcy.
In many respects, the fourth quarter resembled the entirety of 2020 regarding the challenges of uncertainty. The main difference being that the “wall of worry” that the markets were about to climb was more focused on the outcome of the presidential and congressional elections than the need for additional fiscal stimulus which took a back seat to politics in October. U.S. equity markets managed to tread water until November 3rd, but quickly changed course post-election as the market’s uncertainties abated as the hopes for renewed fiscal stimulus were revived.
FED MAINTAINS ULTRA-LOW RATES
The Federal Reserve announced in December that it would continue to support the economy through treasury bond purchases. In November, Treasury Secretary, Steven Mnuchin and Fed Chair Jerome Powell also approved an extension of the Fed’s Commercial Paper, Money Market Liquidity, Primary Dealer Credit and Paycheck Protection Program Facilities until March 31, 2021. All of these emergency facilities have been critical to the recovery and stability of capital markets during the pandemic and should provide continued liquidity to the markets. Additionally, the Fed has suggested that interest rates will remain near zero through 2023.
While low interest rates have been helpful to homeowners and first-time home buyers with record low financing costs, the Fed’s policy has put substantial downward pressure on interest rate bearing investments. Since March, savers have generated next to nothing in the way of interest in cash investments and savings. This has forced many savers to seek investment alternatives in bonds and equities to meet their income shortfalls. This dynamic has been able to help explain in part why equity valuations have remained elevated from a historical perspective. Although rates are expected to stay lower for longer, they continue to remain at the top of our watchlist as any adjustment to rate levels in the near-term will undoubtedly affect the price of financial assets.
US AND GLOBAL ECONOMY
The U.S. economy continued its recovery for the quarter at a slower pace than the prior quarter. As of January 8th, the Atlanta GDP Now estimate for Q4 GDP came in at 8% suggesting that U.S. growth for the year could be closer to a contraction of 6% when the official figure is reported at the end of the month. This is most certainly an impressive recovery considering that the U.S. economy was shuttered for almost two quarters with the most precipitous drop in GDP registering a staggering -31.4% for the second quarter. The continued declining unemployment rate, strengthening housing market and improving consumer finances have collectively contributed to this trend. Although the employment picture and economic activity for the U.S. have improved broadly, it is important to remember that there are still many hard-hit sectors that have not participated meaningfully in the recovery.
The Conference Board’s Index of Leading Economic Indicators for the U.S. increased in November. “But its pace of improvement has been decelerating in recent months, suggesting a significant moderation in growth
as the US economy heads into 2021,” said Ataman Ozyildirim, Senior Director of Economic Research at The Conference Board. “Initial claims for unemployment insurance, new orders for manufacturing, residential construction permits, and stock prices made the largest positive contributions to the LEI. However, falling average working hours in manufacturing and consumers’ worsening outlook underscore the downside risks to growth from a second wave of COVID-19 and high unemployment.” These concerns support the notion that continued monetary and fiscal support will be needed to solidify a robust recovery for the U.S. economy into 2021.
The recovery in GDP growth for most other developed economies is expected to track the U.S. for 2020, but at a weaker pace. Many economists cite the lack of coordination between fiscal and monetary policy for these countries as being the primary reason for the disparity. For the quarter, many European countries were forced to lockdown again in response to surging COVID cases which will undoubtedly put a damper on the growth trajectory for European economies.
US EQUITY MARKETS
Global equities managed to deliver strong returns for the quarter across the board. For many U.S. stock sectors, almost all the year’s return was captured in the final quarter. The broad U.S. market as referenced by the Russell 3000 Index climbed the proverbial “wall of worry” which stemmed from the election and fiscal policy uncertainties. However, its valuation ended the quarter at a 20-year high as evidenced by the forward price-to-earnings ratio of over 24. Many analysts have justified this valuation level based on the potential for greater federal stimulus under Democrat control as well as the reacceleration of economic growth in the second half of 2021 as a result of the earlier than expected rollout of critical vaccines.
U.S. small- and mid-cap stocks outperformed their large cap peers for the quarter. The more cyclically oriented sectors of the market such as industrials and financials outperformed defensive sectors like healthcare and communication services. This phenomenon can again be explained by the potential for added stimulus as the sectors that are more dependent on the business cycle tend to be influenced more by fiscal policies. The international developed markets were in line with the U.S. markets in the final three months. However, they still underperformed U.S. equities for the year.
FIXED INCOME MARKETS
U.S. bond yields adjusted slightly higher for the quarter in the wake of the post-election stock rally. Although this nominal rise in yields put pressure on bonds, the broad U.S. bond market still eked out a small total return for the quarter. The corporate and high yield sectors outperformed the market while intermediate and long-dated U.S. treasuries underperformed.
With yields at multi-decade lows some investors have been tempted to strictly chase yield in some of the riskier sectors of the credit markets. Although we have some exposure to higher yielding bonds in the portfolio and consider them to be a small portion of a well-diversified bond portfolio, we always caution against becoming over exposed to any asset class for sole the purpose of yield. Yields much like stock returns are not guarantees and the return of principal should always have priority to potential yield when investing in bonds. More importantly, we must not forget the primary purpose of bonds in an equity portfolio: to control risk and offset stock market volatility.
2021'S NEW ADMINISTRATION
Our job as wealth advisors includes reporting and analyzing political activity and relaying how the new administration could impact the investment world. After one of the most contentious elections ever, with the largest voting numbers ever recorded, a new administration has taken place.
According to CNBC, the new Democratic control of Congress should help keep the bull market in stocks going with a big boost of fiscal spending, but it could also throw new hurdles into its path, like higher taxes and higher interest rates. They believe economic stimulus, combined with tax hikes on the wealthy and corporations, are all on the table for the new administration.
Based on the platform of President Joe Biden, taxes and managing the pandemic will certainly be focal points. Although it is difficult at the present to assess how quickly and to what extent tax policy will be changed, taxes will inevitably moderate higher as the current code is expect to sunset in 2026. Income tax and estate plans should be reviewed this year to take advantage of opportunities that could disappear under a new code.
Dan Clifton, head of policy research at Strategas Research Partners, expects a first stimulus to come early in the Biden administration and could include payments for individuals, funds for state and local governments, and extensions for unemployment benefits. He expects that package to amount to over $1 trillion and then Democrats would go for a second infrastructure package focused on things like climate change, clean energy, health care and education. He adds that, “There’s a really big debate among investors now about how much you can do with an already divided House and a narrowly divided Senate.” (Source: cnbc.com 1/6/2021)
Could a Democratic Congress push through stimulus programs to boost the economy that could help the stock market? Would this outweigh a tax increase? How will the new administration handle trade talks with China? All these questions and many more like them mean that investors need to carefully watch the policies that will be established by the new administration.
Even though equities are entering the new year at a relatively expensive level. Investors are pricing in the effects of added stimulus, an accommodative Fed, progress in COVID immunizations and improving fundamentals to the market. Most analysts are optimistic for 2021. Barron’s recently surveyed 10 market strategists and chief investment officers at large banks and money-management firms on the outlook for 2021. Averaging their year-end S&P forecasts, which range from 3800 to 4400, the group expects a modest rise in markets for the year. Many analysts anticipate that much of this potential may not materialize until the second half of the year when a greater percentage of the population is expected to be inoculated. This could very well set the stage for a much broader cyclical recovery for the market.
With interest rates at record lows, bonds are not expected to earn as much as in prior years. A rise in yields could put pricing pressure on bonds if inflation accelerates later in the year. Given the call for unprecedented stimulus and the outlook for containing the COVID pandemic in the second half, this could certainly materialize. Out of all bond sectors, long-term treasury bonds are most susceptible to risk as just a 0.5% increase in yields could cause a material price decrease for this asset. Nevertheless, bonds as a broad asset class are still a very important risk control mechanism for stock portfolios.
DISCUSS YOUR CONCERNS WITH US
2020 was certainly a tumultuous year. The flow of economic and political news was overwhelming to say the least. In times where investors are being constantly bombarded by information, it is very easy for one to succumb to their own personal biases which may lead them to reactive investment decisions. Which is why it is ever so important to review your investment strategy in context to your long-term goals and to tune out the noise that may transpire over a week or even a year. Doing so will help to maintain the objectivity of the investment process.
Our advice is not one-size-fits-all. We will always consider your feelings about risk and the markets and review your unique financial situation when making any recommendations.
At Prestige, we design custom portfolios with the goal to both protect and grow your wealth. Our wealth advisors are ready to help you with an obligation free complimentary review of your portfolio. If it's good, we'll tell you. If it's not, we'll provide feedback on things that can help.
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