As we take stock of a year like no other, when we’ve all ridden the rollercoaster known as the Emotional Curve, we are reminded of the fact that health is the one thing, which matters most. This year brought a “Black Swan” event in the form of COVID-19, that ended up disrupting the whole system and forced us into making unprecedented and decisive adjustments to changing circumstances. A “Black Swan event” is a rare, unpredictable event with serious and unavoidable effects, a theory developed by Nassim Taleb in his book “Fooled by Randomness”.
The entire globe endured the effects of COVID-19 early this year, which rocked the economy and the stock market. In the US, the election vitriol stayed with us during the summer and in the end, Joseph A Biden emerged victorious. With the US elections now behind us, we now move on to face our persistent challenge as the new administration begins to tackle its primary task to contain COVID-19. The positive vaccine news from Pfizer and Moderna cannot come soon enough and discussions have begun regarding herd immunity. Herd immunity occurs when a large enough portion of the population becomes immune to an infectious disease and in this case, it would take at least 2 years before we reach that level. So, the distribution and policy response regarding the vaccine will become very important in the next few months.
Although the near-term outlook is muddled, with positive news on the vaccine front, we hope things will improve from here. The policy response to COVID-19 has been on a completely different scale compared with the global financial crisis or any other crisis in the past. Not only has the response been faster and the scale greater than at any moment in peacetime history, but it also involved some unprecedented steps like the Federal reserve buying corporate and high yield bonds. Not only in the US, but the central banks around the world have flooded the markets with liquidity. For example, the aggregate change in the global central bank balance sheet was about $6 trillion leading into the Lehman crisis over 2 years (Jan 2007 to Jan 2009), versus about $9 trillion over the course of 9 months (March 2020 to November 2020). We briefly discuss our global strategy outlook for 2021 and our baseline expectations.
Economy - Our baseline assumes a divided Congress, which implies $1 trillion less in stimulus compared to the scenario if there is Democratic sweep (which we will know on January 5th after the Georgia runoff). Unemployment has declined rapidly since April 2020, but the pace of improvement is slowing. The slack in economic growth should continue to keep the lid on inflation and the Federal reserve will continue to be accommodating until we see a full economic recovery. The housing market continues to strengthen, and home sales may continue to surge as interest rates remain at record lows. We expect that a full recovery of the economy (to pre-COVID levels) may not happen before 2023 and the recovery will be aided by consumer spending, housing and the industrial sector.
Equities - Easy monetary policy and prompt fiscal response has propelled the stock markets to new all-time highs. The bullish sentiments are at extreme levels when compared historically, which incidentally also support a case for further gains in the coming years. To quote an example of strong breadth in the stock market, the percent of S&P 500 stocks above their 200 daily moving average, (in a long-term uptrend) is at its highest level in 5 years (90%)1. But it would be a mistake to just mention the bullish thesis and discount the red flags at this point. The foremost red flag at this moment is valuation. The S&P 500 is trading at about 26 times 2020 earnings and about 21 times 2021 forward earnings, rich by historical standards. Also, we are very well aware of the fact that the post-election year is the weakest of the four-year election cycle, so coming at the heels of such strong gains, I would not be surprised if equities remain range bound for the first half of the year as S&P 500 earnings recover. The US dollar continues to remain in a downtrend as the US Treasury continues to dig deep in terms of the fiscal response to the recent crisis. However, the weak US dollar acts as a tailwind for emerging markets and international equities. Also, with the steepening of the interest rate curve, there might be a strong tailwind for value stocks (financial sector in particular) going in to 2021.
Fixed Income – The Federal reserve is likely to retain an accommodative monetary stance with 10-year treasury rates expected to rise to 1.2% by 20222. We continue to prefer shorter duration fixed income exposure to mitigate interest rate risk coupled with some long duration fixed income to hedge equity risk. We continue to remain constructive on credit risk as the Federal reserve is actively supporting both corporate investment grade and high yield bonds.
Conclusion – We expect the road ahead to be tumultuous as we continue to recover from the effects of COVID-19. As we close this year, we mark a milestone achievement by getting the approval of a vaccine in record time and recovering most of the losses in the equity markets experienced earlier this year. This also reminds us of the power of scientific discovery and innovation, which will once again help humanity conquer a pandemic. Above all, there was one thing that succeeded in this market: ‘Staying the Course’. One could argue that the overall economy was better in 2018 compared to 2020, yet stocks fell that year and are up this year. And so, one thing we have abstained from doing is timing the market. We continue to get calls regarding how expensive the markets are, and how they are doomed to fail and yet since 2013, the S&P 500 has more than doubled. We continue to remain optimistic about the recovery in the US and the world economy and encourage our clients to take a long-term view. The zig and zag continue to be a part of the equity markets and looking at it every day does not make your returns grow but ‘Staying the Course’ sure does.
1Source: Stockcharts.com S&P 500 Percent of stocks above 200 day moving average $SPXA200R 12/7/20
2Source: Value Line December 4th edition
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