Quarterly Market Review: Q4 2020
A New Hope
Paul Dickson, Director of Research
Mark Stevens, Chief Investment Officer
The Star Wars movies began a third of the way through the saga with an episode with the title above. While the Coronavirus pandemic continues, vaccines and economic support efforts provide a significant new hope for the coming years. Just like the Star Wars franchise, it will always be wise not to dwell on the first chapters that transpired over 2020. Instead, look to the subsequent periods as good triumphs over evil. In this case, getting past COVID-19, putting the global economy back on firmer footing, and restoring economic growth.
There are several reasons to believe the recovery will be robust and swift, especially in comparison to the painfully slow recovery from the Global Financial Crisis a decade ago. The pandemic has been an entirely exogenous shock; it was not a failure of the economic model or of capitalism itself that caused the collapse. People were forced to withdraw from economic activity due to a virus, meaning that this was a demand shock, not one of supply or structure. In the Global Financial Crisis, there was a collapse of the financial markets and banks. That, in turn, meant the recovery would start off impaired, without the ability to fully restore credit to the economy in place, and take years to consolidate.
In the present situation, there is no such breakdown of the structure of the economy. While thousands of small businesses closed, the outlook for a rapid recovery in economic activity and demand is such that thousands of new small businesses are likely to start and under auspicious conditions. Interest rates will be low, and—if one takes the Federal Reserve at its word—are likely to stay so for an extended period. Economic rescue packages and employment support from national governments and Central Banks have improved the prospects for many workers and significantly cushioned the blow of the virus. While many remain out of work and economic activity is depressed, much of the worst of the impact was averted by unprecedented efforts by the global public sector.
The Biden Administration Strikes Back—at the Virus and Recession
The incoming Administration has proposed a $1.9 trillion economic stimulus and pandemic response package focused on accelerating the response to the virus and addressing many of the items rejected in previous packages. Among these is another stimulus payment to individuals of $1,400 in addition to the previous bill’s $600. As expected there is more explicit support for State and Municipal governments whose finances have been battered by the crisis and where there has been no appreciable recovery. As the package has been announced prior to the inauguration, we would expect fairly quick negotiations and passage by Congress during the first quarter. The urgency of the pandemic and the related efforts included in the proposal should ease its way.
Before the results of the runoff elections in Georgia, the passage of such a package might have proven difficult to imagine. But the change in majority from Republican to Democratic means that more bills will be considered by the Senate and issues surrounding taxation and spending will be significantly easier for the Administration to get approved. While most legislation will still be subject to the 60-vote minimum to end a filibuster, the Congressional Budget Act of 1974 provides that certain tax, spending and debt limit legislation can be expedited under the process of reconciliation. This process is likely to be used for the proposed stimulus package, especially as the outgoing Administration never passed a budget for the coming year, leaving it likely that it, and the stimulus bill, could be considered together.
Return of the Spending
In addition to a proximate economic support package, other policy goals point to additional stimulus over the coming years. While it may not be until the latter half of the year, the incoming Administration has made infrastructure spending a priority. Most observers agree that after years of false starts on a new infrastructure initiative, such would be politically popular to both parties and would likely be easier to enact. A lingering question is the degree to which such investments will be part of a green push or more pointed at significant surface needs: roads, bridges, rail, etc. Either way, such should improve growth prospects for the coming year, and if interest rates stay as low as they are, they might not be too expensive to finance.
Some of that expense is likely to be covered by tax increases, although the increases proposed will unlikely close the gap. The Biden Administration is likely to seek significant rollbacks on the 2017 tax changes, including a return to a higher marginal tax rate for the highest incomes and an increase of the corporate tax rate to 28%. There will also likely be an imposition of a Social Security payroll contribution for wages above $400,000. These are significant even if they are not revolutionary.
There Will Be No “Phantom Menace”
Fears that the new Administration will cause dramatic changes over the coming two years while it enjoys majorities in both chambers of Congress appear unfounded. The phantom menaces of D.C. and Puerto Rican statehood, or of ending the filibuster, or packing the Supreme Court with liberal justices, will not come to pass. There are too many conservative Senate Democrats—Joe Manchin chief among them—for those controversial pieces of legislation to come forward. While the Affordable Care Act may well be bolstered, pending the Supreme Court’s current consideration of it, there will be no Medicare for All. As much as the infrastructure plan will include environmental considerations, there will be no Green New Deal of the scope imagined by the left-most wing of the House. Despite having a majority in the Senate and having control of the legislative calendar, ambitions will be tempered by the reality of political calculus.
The Rise of the Economy
The economy appears ripe for rebound on a surplus of fiscal and monetary stimulus, and a dramatic recovery in activity as the pandemic wanes. We have noticed that a significant number of economists are revising their estimates upwards from somewhere around 3% before recent events, to 5% and higher. We would not be surprised at a 5.5% recovery in 2021, pending the successful rollout of the vaccine and the economy getting back on its feet. There are still millions of people out of jobs, but demand for goods, and especially services, has been building for many months.
How far the recovery will extend before concerns about the overheating of the economy arise is anyone’s guess. As it stands, there is plenty of slack, but that can be taken up fairly quickly. Inflation has been subdued and the Fed has indicated that it would be comfortable allowing it to run above its long-term target for a while before seeing a need to hike interest rates.
In terms of interest rates, we expect that short-term rates will be anchored by Fed policy and longer rates allowed to rise, albeit quite modestly. The Federal Reserve continues to purchase billions in securities each month with the goal of keeping long rates low in support of the economy. We suspect that as the economic recovery gathers steam, the Fed will allow longer term rates to drift higher, only intervening to make sure the increase is not too sharp. We do not foresee a Fed rate hike until the latter half of 2022 as the recovery is well established. The Fed’s Dot Plot of FOMC member expectations does not see a rate hike until after 2023.
Q4 – Revenge of the Forgotten Asset Classes
The year 2020 will long be remembered for the disconnect between the economy and stock prices. A global pandemic forced a shutdown of the economy that led to an immediate global recession and then led to the fastest bear market decline in history. While the government’s response was swift, the level of COVID cases and death totals grew. Growing social unrest and uncivil political discourse divided the country, eventually leading to a shift in US political power. In response, stock and bond markets posted positive returns with many major indices ending the year at all-time highs. Go figure.
How is this possible? In large part, it was due to a major Q4 advance fueled by investor optimism around the developments outlined above. The planned rollout of new COVID vaccines was pivotal. The result of the November elections also proved essential. Already low rates and easy monetary policy, now married with greater fiscal support from the U.S. Government and the rollout of a new vaccine. This set the table for positive returns across nearly all asset classes in Q4 and provided a scenario that would motivate investors to look for opportunities outside of Large Cap Growth stocks.
In the US, the S&P 500 finished the quarter up 12.2%, but the leadership shifted to Small Caps and Value stocks. The Russell 2000 index shot up 31.4% in Q4—its best quarter in its history—and more than 18% greater than the S&P 500. Small Cap stocks are more economically sensitive and were hit the hardest by the pandemic. Their leadership seemed logical as the prospects for a more normal economic recovery grew. Cyclical companies, dividend payers, and forgotten stocks with low valuations also rebounded in Q4. The Russell 1000 Value index (16.3%) outperformed the Russell 1000 Growth index (11.4%) in Q4 but clearly fell short for the entire year, underperforming by a whopping 36%.
While each of the eleven S&P 500 economic sectors finished the quarter on a positive note, Energy, Industrials and Financials all benefited from the rotation to more cyclical names within the index.
International stocks benefited from the mean reversion trade as well. The MSCI EAFE Index rose 16.1% with nearly all major developed regions outside the US posting double-digit returns for the period. Emerging Market Equities (MSCI EM) was the best performing international asset class, up 19.7%, as the group would benefit most from a synchronized global recovery.
The Force is with Stocks for Now
We expect many of the current conditions to persist and lead to a more durable economic expansion in the future:
- The success of the vaccine will be critical to economic momentum.
- Monetary and fiscal policy should continue to play a prominent role in growth for foreseeable future.
- Low inflation and excess economic capacity should keep interest rates lower for longer.
- Low return expectation for alternative asset classes make equities relatively attractive.
In our opinion, the current state has made market evaluation a bit less complicated—as long as the vaccine has reasonable success, fiscal support remains on the table, the Fed maintains its vigilance, and return expectations on other asset classes remain dismal—it pays to stay long equities. This won’t be the case forever but betting against equities would seem the risky move in the current environment
Historically high valuations would suggest more moderate returns in the future. The current forward P/E ratio on the S&P 500 is roughly 23, well above the historical norm of around 17. A post-COVID earnings recovery, low rates, and the resumption of stock buybacks should all help support higher valuations.
We continue to believe that a vaccine induced recovery that is assisted by an aggressive Federal Reserve and persistent fiscal stimulus will broaden stock market leadership. Prior to Q4, positive returns were reserved for technology-heavy growth stocks and little else. Tech names disproportionately benefited from the work from home environment. Just as important, growth stocks are long-duration assets, meaning much of their value is based on future earnings. Low interest rates make those future earnings—and, in turn, the stock itself—more valuable. Capital poured into this narrow group—pushing a select sub-set of indices higher—but left most of the market behind. That changed in a major way in Q4 and we expect that trend to continue. This should allow asset classes that sell at a discount (small caps, value stocks, and international equities) a chance to further narrow the valuation gap.
Lastly, the rotation in market leadership in Q4 was a reminder that diversification is in fact not dead. The importance of maintaining even modest exposure to out-of-favor asset classes was never more evident in Q4 when Small Cap stocks outperformed Large Caps by nearly 18%—effectively erasing the return gap in less than one quarter.
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