Jan 07, 2021
The haste to put 2020 in the past is understandable on many levels, though from an investment perspective, equity investors may do so with mixed feelings. This improbable year finished strongly for stocks with most broad market averages ending the year near or above their historical highs.
2020 gave us a bear market and a bull market in the same year, each running its course in the shortest timeframe ever. Investors’ focus on reconciling a thriving stock market in the midst of economic despair has shifted to the transition of a recovering economy in the midst of the pandemic’s worst surge and the deployment of approved vaccines. Over the full year, investment strategies were significantly affected by the extreme disparity between winners and losers, underscoring the non-uniform impact of the pandemic on the economy and individual companies.
We will focus most of our comments on what this means as we look at the investment opportunities ahead. We do this knowing that our 2019 year-end note held few clues as to what investors would be dealing with in 2020. We also offer some perspective on bonds in this era of near zero-level interest rates.
2021 – Looking ahead
The consensus outlook for 2021 is generally optimistic:
- Markets are in the midst of the greatest injection of global liquidity and economic stimulus ever seen, including sending checks directly to its citizens.
- The Federal Reserve is committed to leaving overnight lending rates at near-zero for the next three years.
- Mass inoculation is expected to give us the upper hand over the coronavirus by late summer.
- Pent-up demand should disproportionately benefit service-oriented companies and industries that were most disadvantaged by restrictive policies as consumers re-engage in economic and social activity.
- Consumer spending is primed to rebound, facilitated by historically high personal savings rates and additional stimulus programs.
This optimism is tempered by:
- High equity valuations for the general market, extremely high for select winners in 2020
- Risk of higher taxes and less business-friendly regulation with the outcome in Georgia
- The long-term economic costs from our massive accumulation of debt
- Deflationary forces reversing course (globalization, wage gaps, demographics); inflation likely to firm as economy gains strength
- Positive sentiment indicators (usually a contrary signal) and signs of speculative froth
For most investors, these concerns do not seem to be threatening enough to stand in the way of the unprecedented confluence of monetary and economic support. This level of stimulus, however, is not sustainable, though there is no timetable on when or how it will be reduced. While investors will welcome a return to more normal economic activity, markets have not been particularly hospitable when there is talk of removing monetary safety nets. It is logical to expect this transition will be challenging. Until then, investors can justify keeping their equity commitments full while this window of supportive liquidity conditions remains open, now probably enhanced by the change in the Senate.
As we look forward, we do so with the perspective that 2020 was the most difficult year for value investors since 1999, the peak of the Tech Bubble. The 12-month relative performance of value stocks versus growth was the worst in history. This also left value stocks trading at some of the cheapest levels in their history. While cheapness alone is not a reason to expect better returns, cheapness with a catalyst is. That catalyst is a global economic recovery.
While we have maintained a growth tilt in our portfolios, the vaccine announcements make a stronger case that economically sensitive stocks will fare better in this next stage of the recovery. Growth stocks benefited from multiple expansion when broader economic growth was weak. Investors will now have the opportunity to find growth without having to pay up so dearly for it.
The strong rebound of value stocks in the second half of 2020 is encouraging. Our Value Equity, Yield-Focus Equity, and Small-Cap Equity strategies were positioned well to take advantage of this move. Our enhanced equity selection tools were helpful in identifying new value opportunities.
We will add that we do not think value’s opportunity will necessarily be at the expense of good returns from growth stocks. The Meritage Growth Equity strategy had an excellent fourth quarter, led by strong returns in the semiconductor space, an area that had stood out to us earlier in the year as an attractively valued growth opportunity.
When pent-up demand runs its course, the sustainability of the value rotation will depend on the longer-term underlying economic growth rate. Some have argued that the magnitude of the monetary and fiscal relief will unleash an extended period of robust growth. This narrative about the return of the Roaring 20’s is intriguing, but just as likely we will see a return to the slower growth environment that followed the Financial Crisis and favored secular growth stocks – something the markets will be monitoring closely.
The fixed income conundrum
In the current interest rate environment, the returns from good quality, intermediate maturity bonds will contribute little to an investor’s overall returns for however long it takes bond yields to reset to higher levels. That reset may have begun, but it will likely take an extended period of time to complete. Even as the economy continues to improve, the secular trends of excessive debt, poor demographics, and technological advances acting on the economy will likely keep rates from rising to levels seen as recent as three years ago.
The alternatives to pick up additional yield involve higher levels of risk. Depending on the individual client circumstance, it may be appropriate for balanced portfolios to maintain equity exposure at the higher end of their equity target ranges. For others with less capacity for risk, low bond yields are not enough to forego the safety and cushion that bonds provide in a balanced portfolio.
In the meantime, most fixed income investors recorded good returns in 2020 due to the decline in interest rates, from historically low levels to all-time lows, which drove bond prices higher. The longer the bond maturities, the stronger the gains. Bonds have now run out of room to benefit from another broad decline in interest rates.
For those who generally hold their bonds to maturity (like us), a good part of these gains are ephemeral – they simply pull forward future gains that now show in the 2020 calendar year, leaving smaller reportable returns available in future years before the bonds eventually mature at par. Capturing these bond price gains by selling the securities and reinvesting in new bonds (like with stocks) does not work in the same way and usually ends up costing the portfolio.
Going in the right direction
We would not be surprised to see above-average volatility as the rest of the political pieces and priorities come together and the latest stimulus program works its way toward the intended beneficiaries. While there will be the usual noise along the way from the various media sources, the markets will be focused on the upcoming release of corporate earnings and management commentary regarding any changes in their view of the next several quarters. Our exit from unchartered waters is happening, albeit at a slow and unpredictable pace.