2020 is over. Finally.
After a year of so much disaster and uncertainty, we thought it would be a relief to look ahead to 2021. Between the events which unfolded in Washington, DC and the daily coronavirus death toll setting new records, the first week of the new year has made that harder. Yet we expect matters to improve over the course of the year and we remain cautiously positive.
For its part, the market has been looking at 2021 and beyond for months now, part hoping and part expecting that the pandemic would pass, life would return to some semblance of normality, and the economy would roar again. To date, we’ve witnessed a remarkable rally, with the S&P 500 up 70% from its March low and even up 18% for the yeari (Display).
The bull case for stocks from here is that pent-up demand will finally be unleashed in the economy in early- to mid-2021, that corporate costs won’t return as quickly as they were cut, and that investors will continue to be pushed out the risk curve by low interest rates. Yet risks still loom for the economy and the market. With the major decline in economic activity expected to persist for the next few months until coronavirus vaccines are more widely available, scope remains for significant economic damage and scarring.
Overall, we’re positive on the economy and cautiously optimistic on the markets, believing much of the bull case laid out above. As ever, some areas appear more attractive than others and it’s likely that the path from here won’t be smooth. Below, we ring our perennial bell for a balanced and long-term perspective in our clients’ strategic allocations and highlight areas of special interest and opportunity.
A Resurgent Consumer—Top Line Benefits
After a jaw-dropping economic decline in 2020, the pace of activity has picked up in recent months. While we’ll likely see a wobble through the winter, the recovery should continue in 2021 and reaccelerate in the second half of the year thanks to the vaccine rollout. Bernstein’s Biopharma research team estimates that the pandemic will begin to ebb around February, and we should have enough vaccine doses to reach herd immunity in the US in the middle of the year (Display).
A critical driver for the economic recovery will be pent-up demand for goods and especially for services. With so much of the US economy driven by services and with many in-person activities choked off by the pandemic, a rebound in travel, hospitality, and leisure industries will enhance the recovery in GDP once COVID restrictions dissipate.
To fuel that spending rebound, our eyes are focused on household balance sheets (Display). Unlike a typical recession and recovery, people’s savings rates largely grew and their balance sheets remained healthy, as government stimulus helped backstop incomes. In some cases, saving was precautionary. In others, it was created by simply not being able to spend money on the things we normally would. As the economy reopens and this cash flows through it, we expect an abnormally large tailwind for growth.
Cost Cuts—Fueling Operating Leverage
One surprise in 2020 was how quickly companies were able to take costs out of their operations and protect profits. Similarly, as revenues rebound in 2021, we expect many companies will be able to grow their revenues faster than costs. As a result, we expect a substantial amount of operating leverage to allow pre-tax profits to grow strongly, as witnessed in previous recoveries. Furthermore, with interest rates so low and so many companies tapping credit markets in 2020, there’s also likely to be an unusual amount of low-cost financial leverage, which will also amplify earnings growth.
Finally, not everyone has been able to weather this pandemic as comfortably as the national average. We’ll discuss the risks around this below, but further government stimulus could benefit businesses on the brink and low income households with a high marginal propensity to consume—not only sparing millions of people undue misery but also fueling a faster, more widespread, and balanced recovery.
Uncertainty – Down but Not Out
With many reasons to be optimistic, is it time to sit back and let the good times roll? Not quite. Risks do remain.
From an economic perspective, the critical issue for the recovery will be economic scarring. A recession unlike any other stands poised to lead to a recovery unlike any other. Depending on the policy path taken from here, it may be notable for who gains and who is left behind.
The economic damage has been concentrated in certain sectors of the economy and certain groups in society. To the extent that the recovery is similarly uneven, that could threaten its pace and robustness. Recessions are usually a catalyst for companies to adopt new technologies to improve productivity. In this case, industries with significant labor components have been those most affected by the pandemic. If they struggle to rebound, employees in those sectors and the labor market overall are likely to struggle as well. Since many of those workers have relatively high propensities to consume, their demand as customers may also be weak and serve as a headwind to the recovery.
In addition, companies that had to issue debt in order to survive the pandemic may find the burden of that debt oppressive even with interest rates low and growth rebounding. Economists worry about a debt overhang—if a large portion of corporate cash flows need to be spent servicing debt payments, some companies may not be able to invest more in productive capacity and hiring. That in turn reduces the revenues of the businesses who build the factories and manufacture the equipment used by those companies and slows the recovery in the labor market.
The concentration of damage to low-income households and now-overindebted businesses poses the greatest threat to the recovery. This threat can be counteracted by fiscal stimulus. We believe that while their margin in the Senate is slim, unified Democratic control of both houses of Congress as well as the White House means that if further stimulus is necessary, it is likely to be forthcoming.
Another concern relates to interest rates and earnings multiples. Put simply, interest rates at current levels justify optically high valuations for stocks, especially those with a meaningful growth trajectory. One major controversy that we expect to emerge as the economy recovers will be around the timing and degree of interest rate rises. Whenever that time comes and rates begin to rise (Display), it may pose a headwind for equities. However, a lot of events, many of them good, must happen before that becomes a clear and present danger to stocks.
Opportunities During Transition
We’re often asked by clients how to deploy capital they’re holding on the sidelines. Our answer always starts by looking first to that client’s long-term strategic asset allocation. Investing pro-rata across a client’s allocation is often the simplest but most appropriate action to take.
And yet, for a variety of reasons, some investors prefer looking outside of their allocation for investment ideas—perhaps toward areas that have been out of favor. Firmly in that category today are small-cap stocks, Value stocks, and international stocks (in both developed and emerging markets). After years of relative weakness and for reasons as straightforward as hopes for accelerating economic growth, these areas performed better than their relative peers (large caps, Growth and US) in the fourth quarter, and opportunistic investors have thus been assessing whether a leadership change is afoot.
Other areas of interest to us, especially as tactical opportunities, include smaller community banks whose stocks trade at discounts to tangible book value but whose businesses are positioned to grow and earn attractive returns on equity. In the credit markets, we see more opportunity off the beaten path—in emerging markets and areas of securitized credit. While Tech and Growth stocks have outperformed recently, those companies are not a monolith—we continue to like some of them more than others. Finally, we continue to like companies with meaningful long-term tailwinds such as sustainability and health, while also keeping valuation in mind.
2020 was a surprisingly strong year for stocks, a circumstance made possible by the policy response to the pandemic and made remarkable by the scale of damage to the economy. A survey of Wall Street strategists a year ago suggested the market would be up 4% in 2020. In the end, it was actually up 16% before dividends. Had you asked those strategists where the market would be if there were a pandemic in 2020, their year-end targets might have been around where the market was at its depths in March. But had you told them what interest rates and earnings estimates for 2021 and 2022 would be at the end of the year with no additional context, they’d probably have put the market around where it is now. All of that goes to show that:
1) Some of the most important events can only be prepared for—they can’t be predicted; and
2) Even when you know what the major events will be, there’s no guarantee you’ll be able to appropriately position your portfolio for the (unknown) market impact.
Heading into 2021, there’s every reason to be optimistic. At the same time, we lean on a definition from Elroy Dimson of the London Business School, that risk means more things can happen than will happen. Last year, and many before it, have borne that out.
As we prepare for 2021, we’re cautiously optimistic about the economy and the new bull market. But we’re positioned for a range of outcomes, picking our spots carefully, and monitoring the data that we believe will drive investors’ and policymakers’ decisions as the economy rebounds. We believe that prudent approach will benefit our clients not just in 2021, but also over the long run.