CIO 2021 Market Outlook
As we begin to think about the capital markets for 2021, we always start from the perspective of our clients. When we created our company in 2014, we selected the name Asset Advisors for a reason. We view ourselves as advisors and counselors to our clients which, in our minds, connotes a deeper level of service than simply managing assets. With this as our guidepost, we contemplate the primary issue for clients: asset allocation. There have been numerous studies on the impact of asset allocation with respect to the long-term results for any investor. Given the strength of the equity market in 2020, we believe many investors will find that their general split between stocks and bonds is out of line with their investment policy goals. If nothing has changed with respect to the long term needs for the assets you possess, rebalancing back to targets will allow you bring your portfolio back into line with your long-term objectives.
At an interval, such as year end, we also think that is an appropriate time to review your asset allocation structure. This review should be taken in light of your current situation, liquidity needs, any expectation of large portfolio inflows or outflows and any other factor that could influence your asset mix. Please contact us if you would like to review your current situation. For clients that utilize our model portfolio strategy, the Asset Allocation team is working hard to update the models which will be ready for distribution in March.
No outlook can be complete without reviewing the previous year. In 2020, we came into the year with the economy on generally solid footing, unemployment was low and seemingly going lower. The structure of the employment market was good with broad based participation. Real wages were growing faster than inflation, which was also low. The wage growth story was also very positive because wages were growing fastest at the lower levels of the economic ladder. This type of wage growth could have led to further economic gains because of the consumption driven nature of our economy and the broad base of increasing wage gains. Consumer confidence and business confidence were both increasing and the combination of all of these factors led us to believe that 2020 would certainly be a good year for the economy, if not the capital markets as well.
Of course, everything started to change in late February and by early to mid-March things really began to change. At Knights of Columbus, we sent our first people to work from home on March 12th which included the investment team. By March 17th, all our employees were working remotely and we, like every other business, had to adapt to this new reality. We know that KoCAA’s success story was met by many other businesses in a variety of industries that rose to the occasion as well. Other businesses, mainly in hospitality, leisure and travel were decimated and are just starting to see some activity.
This brings us to the virus as the central tenet and pivot point of our outlook. As a registered investment advisor that is a subsidiary of a large insurance company, KoCAA receives prognostications from a variety of Wall Street, investment management and economic research firms. All of these reviews are well done and complete with significant charts and graphs to use data to provide an underpinning for their current market views. Our 2021 outlook is significantly tied to the virus, because we believe that widespread distribution of the vaccines and herd immunity are the keys to unlocking the economy.
Part of the reason for this central tenet is associated with the actions of our elected officials with respect to the lockdowns. We saw the initial lockdowns in China and eerie footage from Italy with empty piazzas and of course the never-ending hunt for toilet paper and Lysol wipes that dominated the U.S. this Spring. History will judge the efficacy of the lockdowns that we saw in our own country, but the lockdowns and fear of the virus led to the significant contraction global and domestic in economic activity. As governors around the U.S. enacted the, in my view, pernicious lockdowns, many seem unwilling to concede that perhaps they weren’t the best policy. I believe this is a global health and a humanitarian crisis and getting the economy open with people working and children back in school will likely have very positive human and economic effects.
The economic downturn was severe with quarterly GDP falling 5.0% in the first quarter and 31.4% in the second quarter. With dividends reinvested in the index, the S&P 500 index returned -19.6% for the first quarter after hitting its’ low for the year on March 23rd. As talks of a vaccination and a dip in viral infections occurred, the S&P 500 returned +20.5% for the second quarter of 2020, even though economic activity fell precipitously in the second quarter. We saw a sharp economic rebound with GDP positing a 33.4% gain in the third quarter and the Federal Reserve Bank of Atlanta is estimating fourth quarter GDP growth of 10.4%. This was an amazingly fast downturn and equally fast rebound from the depths of the market collapse in the early part of the year.
If the vaccine and herd immunity are successful, we believe that the economy can perform quite well. However, if the virus and its’ mutations prove to be a stronger foe or the mutations are resistant to the vaccines, this easily could lead to a receding economy. So ultimately, we have all eyes on the vaccine and the virus because we believe they are the most significant variables for the direction of the economy.
We are still forecasting a moderate roll out of the vaccine and believe we will see more robust economic activity in the second half of this year through the first half of 2022. We remain committed to long term asset allocation as previously mentioned and are not recommending that investors take a vacation until July. One only needs to look at this week as “exhibit one” as to how impossible it is to time the market. Many prognosticators believed that if the Georgia run off resulted in a 50/50 Senate split, as it did, that the stock market could correct as much as 10% due to concerns over a more liberal agenda, with higher taxes and significant government spending. Well the Democrats did win Georgia and the stock market, as measured by the S&P, saw a price return of +1.8% for the week. To put a bow on this week’s market action, the thinking is now even with the likelihood of higher personal and corporate taxes, a Democratic controlled government will lead to higher stimulus and higher spending and this will be positive for the economy. We did see some rotation out of tech into banks, for example, but this week’s movement of the market only confirms our conviction that you cannot time the market.
For equities, we are trying to evaluate if the returns of 2020 pulled forward some of the return of 2021. With dividends included, the S&P 500 was up over 18% in 2020 even with the weakness due to COVID-19. With dividends included, the S&P was up over 65% from the March 23rd low through the end of the year. That is a significant move by any standard and this is one of the reasons we think some of the 2021 returns may have been pulled forward.
Using Bloomberg as a data source, we see that the S&P is trading at 22 times forward earnings and this is above its 16.6 times 25-year average. When looking at the forward P/E versus long term averages, one can see that valuations appear a little stretched. When you break the index down by the top 10 names and then the rest of the index, the valuations do not appear to be as stretched.
|Current||25-year Average||% of average|
As we consider stocks, and look at market multiples, we believe investors need to recognize that for these valuations to hold or improve, we need earnings to increase or there is a greater likelihood that stock prices correct to bring valuations back into line. Given the pent up demand from economic lock downs and the amount of excess savings that have been built up, we are looking at the four quarter period from the start of Q3 2021 to the end of Q2 2022 that could be a period of very strong economic growth as the economy opens more broadly, travel begins to resume and consumers begin to spend. Again, this is predicated on the success of the vaccine and/or herd immunity.
A word about stock prices and valuation. I am always reminded by the famous economist John Maynard Keyes’ saying, “the markets can remain irrational a lot longer than you can remain solvent.” In my view, the increased focus on passive management has naïve dollars flowing into the very largest names causing them to become even higher priced and thus causing their P/E ratios to become even more stretched. This is a market trend we will need to continue to watch as we move through 2021 and beyond.
Shifting to bonds, we start with a look at inflation. We came into 2020 with CPI running at 2.5% on an annualized basis when the index was released in January 2020. The last report detailed inflation through November and the CPI stood at 1.2% and was 1.6% when you factor out food and energy. Much of the stimulus and fiscal moves have been designed to avoid deflation. Regular readers of my monthly Market Insights column will recall several discussions on the need to avoid deflation because of how difficult deflation is to reverse. Nevertheless, we are indeed in a low inflation environment and to keep rates low to encourage borrowing, the Fed has persisted with the bond buying program. Because not all investors are ebullient about the stock market, we continue to see strong demand in the bond market.
The following table uses the option-adjusted spread (OAS) as the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to consider an embedded option. Typically, an analyst uses Treasury yields for the risk-free rate. The spread is added to the fixed-income security price to make the risk-free bond price the same as the bond. In simple English, the option adjusted spread is the extra yield earned by investors for holding these various corporate bonds versus a corresponding Treasury.
What you will see in the attached table is that we saw yield spreads hit 300 to 500 basis points over Treasuries during COVID-19 when looking at A to BAA issues of a variety of maturities. During the 2008/2009 Financial Crisis, these rates were even wider running 400 to 600 basis points over comparable Treasuries. Spreads widen when investors demand more yield because of a perceived level of risk. Yield spreads can also widen on a technical or supply/demand basis.
During COVID-19, while the stock market grabbed a lot of the headlines, bonds performed well because yield spreads came in dramatically. This spread movement was driven by the demand of investors to hold bonds both for income as well as to diversify and hedge some of their equity bets and bonds are now fairly expensive when one considers the paltrier yield spreads currently available.
|Index||Current OAS (1/5/2021)||1 Year
|COVID Wides (3/23/20)||Financial Crisis Wides (10/24/08)||Chg. Since COVID Wides|
|‘A’ Index (~5yrs)||51||55||55||303||617||-252|
|‘A’ Index (~10yrs)||76||74||72||303||528||-227|
|‘A’ Index (~23yrs)||118||110||110||302||474||-395|
|‘Baa’ Index (~5yrs)||91||96||95||486||668||-395|
|‘Baa’ Index (~10yrs)||126||129||122||473||636||-347|
|‘Baa’ Index (~23yrs)||177||182||175||450||556||-273|
Source: Bloomberg Barclays – US Intermediate Credit ‘A’ (~5yrs), US Credit ‘A’ (~10yrs), US Long Credit ‘A’ (~23yrs), US Intermediate Credit ‘Baa’ (~5yrs), US Credit ‘Baa’ (~10yrs) and US Long Credit ‘Baa’ (~23yrs)
When we look at the bond market performance of 2020, we look at the Bloomberg Barclays Aggregate Bond Index. This index returned 7.51% for the year, even though 10-year Treasuries had a yield range of 0.51% to 1.92% and averaged 0.90% for the year1. The remainder of the strong performance for the index in our view can be attributed to the appreciating price of the bonds due to the narrowing of credit spreads.
This leads investors to question the value of holding fixed income. Many say that investors are flocking to stocks given the low rates in bonds and given the TINA principle (There Is No Alternative). We believe that even with low yields, bonds provide income and will serve to hedge equity volatility. Further, a careful review of shorter date, longer date and private credit opportunities may provide investors the ability to drive some income and to mitigate some of the volatility inherent in equity portfolios.
Finally, we will have a short discussion on international investing. Recently, as the dollar has been weaker, international stocks benefitted. We also continue to believe that the sheer number of international companies provide both a return and a diversification benefit when added to a portfolio of predominantly U.S. equities. The foreign markets have the same COVID-19 risk and the developed European markets, Japan and Australia may see faster vaccine roll out than some of the emerging markets. We do believe that the central tenet of the direction of COVID-19 is as valid for the foreign markets as it is for the U.S. market. We are, however, unwavering in our long-term view that prudently allocated portfolios should consider an allocation to non-dollar denominated investments.
Finally, let’s discuss some of the current trends in the economy. Will people flee the cities for the suburbs forever, will we work remotely in a greater way in the future? What does this mean for real estate? These are all questions I have heard from clients. At a high level, the attraction of suburban living may not abate quickly, but we think the published obituaries for cities like New York may be premature. However, cities are going to need to regain safety as an inducement to begin to bring people back. We too, believe that remote work will likely be in the mix going forward, but part of working together in the office is the comradery that is achieved when working with colleagues in person. I miss being able to be in our trading room to discuss market moving events or having impromptu discussions on a potential trade. I can speak of KoCAA, we are better together in person. We have made judicious use of Teams and conference calls, but I think the investment staff will be back in the office when it is safe, and we suppose other companies will follow suit.
Ultimately, we believe that like 9/11, after the initial shock subsides and, in this case, the risk of the virus wanes, we will begin to divine the true long-term trends. For now, we are watching commercial real estate and I believe it is fair to say, no one knows with any certainty exactly how the future for remote working will shake out. From an investment perspective, we watch and remain flexible to take advantage of opportunities as they arise.
In summary, we are bullish on the economy if we can get the vaccine rolled out more broadly or herd immunity becomes a reality. We think the faster growth will be in the latter half of this year and the first half of 2022. All eyes need to be on the vaccine. We believe the positive attributes that the economy displayed before COVID-19 can be resumed because this was not a recession driven by economic excesses. We think the stimulus was important to keep people and companies afloat until we get through to the other side. As we now know the construction of our government for at least the next two years we will be evaluating tax and spending policies to determine the impact on both the economy and the markets.
As you are evaluating your present situation and, ponder these issues, please let us know if we can be of service.
CIO of the Knights of Columbus