Our hearts reach out to all of you touched by the tragedy and financial impact of the pandemic.
US stock markets performed remarkably in the face of an historic global catastrophe. Swift and bold action by the Federal Reserve (with lessons learned during the Great Financial Crisis) buoyed financial markets in the face of what could have been a disastrous year on the investing front as well. With US stocks down 30% in March, no one would have believed that the S&P 500 Index® could finish the year up 18%. Other markets and indices significantly rebounded as well. The EAFE (foreign) index ended up 7% while the MSCI Emerging Markets Index rose gained 18% and the Russell 2000 (small cap) Index added 7%.
In March and April, when fear was highest and markets lowest, we explained the stock market collapse was not reflecting economic or market dynamics, but was “event-driven”, and therefore temporary. Almost all our clients stayed invested and were rewarded. Our Time-Horizon Strategies, which minimize short-term impacts by keeping investment appropriate to needs, provides greater peace to weather sell-offs and even spend comfortably in retirement with less worry about portfolio values.
As we enter 2021, financial markets are projecting that life will return to normal later this year. We agree, seeing enormous pent-up demand for discretionary spending. Bank savings (measured by the Fed as “M2 money supply” has increased some $4 Trillion since March. Markets anticipate that much of this cash will funnel into the economy, leading to an economic boom once vaccines are taken and the viral spread tapers off. Economists we respect are projecting 5% GDP growth for both this year and next.
Markets are forward-looking and have already “priced-in” these expectations. Given the economic backdrop and rising COVID cases, the momentum of the market’s trajectory is both remarkable and concerning. There is good reason for optimism, but some areas of the market are outright euphoric. Speculation is high and IPO’s, Special Purpose Acquisition Companies (SPACs), and segments tied to genomics, renewable energy, tech innovation, etc. are ridiculously valued as investors chase sky-high prices. Investor sentiment is high while valuations are elevated, which is not ideal. An unforeseen event could ignite a significant correction amplified by evaporating optimism. This is not a forecast but a valid concern for near-term risk. We advocate keeping cash to meet anticipated expenses for six months or so.
Bonds are no longer the income producing assets they once were. With economic recovery in progress, interest rates are rising, and bond prices are falling. In August, the yield on the 10-year Treasury Note fell to an all-time low of 0.52% as investors feared a second virus wave. Today the yield is double. As the rebound continues inflation will come with it. Over the year, rates will likely return to what we saw a couple of years ago, 1.5%-2%, consistent with inflation. We will have a few months this year where inflation readings come in significantly higher compared to 2020 and the financial press will extrapolate it into an impending inflationary spiral. We don’t see inflation becoming unmanageable given what we see farther down the road. The only value of bonds now is to moderate downside portfolio risk, which is important to many investors.
When appropriate, we will utilize structured notes and private real estate in pursuit of meaningful income in our strategies. These are less-liquid vehicles, which we’ll be happy to discuss with you. While our use of them is measured, they can be great complements to stocks to achieve long-term client objectives while core bond returns are expected to hover near zero for years to come.
There are several issues we will closely monitor going forward. Markets are anticipating an explosive “recovery” in spending that should make 2021 an outsized year of GDP growth. We remain vigilant and focused on ‘what’s next?’. What happens when tomorrow’s good news is behind us? When government stimulus is no longer needed, and liquidity injections slow down? When investors see all the good news fully priced into asset values, what lies ahead is a rockier landscape.
Optimistic sentiment is being rewarded in today’s markets based on good news yet to come. This is our primary concern for 2021. To avoid a meaningful market decline, it is imperative that companies generate the earnings needed to justify today’s rich valuations. Any significant shortfall and a correction are likely. While downside volatility is always unsettling, we strongly believe the second half of 2021 ensures a profitable year for equity investors.
Secondly, we’ll monitor whether enough inflation stays in the system to keep “value” stocks outpacing the “growth” segment. The long-awaited value resurgence has just begun and has lots of hurdles to match the long run growth enjoyed contrasted to value. If we resume the “low growth” economic environment of the recent past (our base case), value may not have the tailwind necessary to continue its resurgence and we will adjust the sails on portfolio allocations once again.
Third, will foreign markets close the performance gap of the last decade vs. US stocks? We have written previously that international stocks are comparatively cheaper, have higher growth rates, with higher dividends to boot. We believe the US dollar is likely to continue to trend lower vs. foreign currencies, which will provide additional fuel for outperformance. Given these factors, we expect to increase our international exposures further during the year. For longest-term (usually retirement) accounts, we also employ Dimensional Funds which you may not be familiar with as they have limited access. They are very low expense, pension-style funds oriented to small cap and international exposures and managed by market economists, including several Nobel Laureates. They tend to do very well in up markets.
The last issue of concern is how government policy will impact economic growth. The political landscape has changed and so will tax policy and regulation. We don’t expect significant tax increases this year as we put an end to the virus, get economic growth back on track and getting those displaced back to work. We have exploded the federal deficit and in 2022 raising taxes will be a larger conversation in Congress. Regulations will tighten around the edges this year but in 2022-23, will likely lower profitability and growth for some sectors and benefit others. We expect a modest corporate tax increase. After a sharp decline from 35% to 22%, it will likely come back towards 25%. Income taxes for those earning over $400K are also likely to increase. Much remains unquantifiable at this point. When all the good news is in the rearview, bad news is all the market can see. So, we may need to respond and back off risk late this year or into 2022.
But in 2021 we our clients to party like it’s 1999! We say go for it! We keep a close eye on exposure to risk assets, as we know that at some point, we will have to seek safer shores for expected gains. We look forward to resuming normal life this year and want you to feel secure in doing so. We invite you to schedule a call to discuss your situation, so you can go live life, because we’ve got your back!
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