We can all agree that 2020 has been anything but an ordinary year. In March, the U.S. and much of the world went into lockdown due to the escalation of COVID cases, hospitalizations, and, unfortunately, deaths. Consumer and business spending plummeted, and economic growth dramatically declined by 20% during the first half of the year. In response, the federal government injected over $3 trillion to support our strained economy, and the Federal Reserve bought over $3 trillion in bonds (U.S. Treasury and agency, municipal, and corporate) to calm and bolster the stability of the financial markets. The magnitude of these interventions was unprecedented in U.S. history.
In the midst of the pandemic, 2020 has also been defined by a contentious election year. While we hoped to author an article that carefully covered our perceptions of the outcome on our clients and work, at this moment in time, much remains unknown. As we write this on November 10, 2020, former Vice President Biden is the President-Elect (awaiting official certification by the Electoral College in December). It appears we will have a Republican Senate, although this result is pending Georgia Senator runoff elections in January. The expectation of a divided government will likely result in a degree of legislative stalemate – a status quo, if you will. The lessened likelihood of changes to federal laws, especially tax law, has seemingly boosted the equity markets. However, should the outcome of the elections result in a blue sweep, the resulting increased ability to implement broad tax changes may have consequential impacts on many high net worth households and estates, as discussed in our September article, Are Tax Increases on the Horizon? We also are waiting for more direction from the anticipated administration on spending priorities and the agenda for re-regulation.
Moreover, we find ourselves potentially closer to an inflection point in the battle against COVID. Recent announcements by Pfizer and Moderna of promising late-stage drug trials have the potential to be a game changer with respect to our economic recovery.
Clearly, there is much to learn and digest over the coming days and weeks in relation to our nation’s political agenda, the course of the virus and recovery, and how that all translates into our client work. However, please see our most current thinking below as to where 2021 may take us.
Looking ahead, we expect a modest 1-2% GDP growth rate into 2021. We note a surprising bounce back in the U.S. economy during the third quarter of this year, with growth up at an annualized rate of nearly 32%. This helps offset some of the overall economic deterioration from the first half of 2020, although estimates of GDP growth for the whole of 2020 range from -2% to -4%. Our GDP estimates for 2021 are within a wide range of estimates we see in the marketplace (which span from 1% to 4%). This range underscores the uncertain economic environment predicted by many. As a result, corporate earnings estimates are highly undefined for 2021 as well. And, of course, much will hinge on the potential rollout of a COVID vaccine or a change in the course of the pandemic, as well as additional federal government stimulus.
"...much will hinge on the potential rollout of a COVID vaccine or a change in the course of the pandemic, as well as additional federal government stimulus."
Our growth estimates account for a federal deficit that continues to grow. As of November 10, 2020, the estimated U.S. debt is $27.2 trillion. Given an anticipated annual deficit of over $1 trillion for Fiscal Year 2021 (8% of GDP), our national debt could cross the $30 trillion line within two years. One of the potential impacts from the increasing debt level is a slowing of overall economic growth. Nonetheless, with modest productivity growth and an increase in population, we believe growth estimates are reasonable at 1%+ (especially in the longer term). As a result, company earnings in 2021 should also be modest.
Stock Market Resilience and Fragmentation
Recent positive news about a possible COVID-19 vaccine has added to the upbeat mood on Wall Street. The S&P 500 Index is up over 8% in the first 10 days of November, and up over 11% year-to-date. This performance was notable, given the huge drop in the markets in March. The path this year has been volatile, with markets down over 20% at some points in March and April. Uncertainty and volatility will be the words that mark 2020 in financial market history.
The most pronounced trend in the stock market this year has been the significant outperformance of popular, higher valuation technology stocks, especially the S&P 500’s five largest companies, which are referred to as the “S&P 5.” In particular, the companies displaying lower valuations (e.g., low price-to-earnings, low price-to-book value, highest dividend yields) have materially underperformed the most popular companies. For 2020, the S&P 5 stocks, which are approaching 25% of S&P 500 market capitalization, have increased in value approximately 45% versus a much lower 2% for the rest of the index through mid-November. This has truly been a bifurcated market – a market of two stories and two trends.
"This has truly been a bifurcated market – a market of two stories and two trends."
We last experienced such a dramatic market split during the dot-com bubble of 1998-2000. One possible reason for this divergence is the increasing participation of retail investors (e.g., individuals, day-traders) in the stock market. Less sophisticated investors tend to be trend followers (momentum investing) and focus investment in the most popular companies and those that are performing the best most recently. Eventually, the most popular stocks become completely divorced from their fundamental business values, creating a bubble in that segment of the market. We expect professional investors will seek to take advantage of the mispricing in the market and rotate out of the higher valued companies and into businesses that are more appropriately valued. There has been some evidence of this rotation taking place more recently.
Low Interest Rates and the Limited Fixed Income Opportunity Set
Looking to interest rates, guidance from the Federal Reserve indicates that rates are expected to stay low for at least 24 to 36 months, at least on the short end of the U.S. Treasury curve. Yields on U.S. Treasury securities two years and shorter are at or below 0.20% (basically 0%). In early January, two-year U.S. Treasury notes yielded over 1.5%, resulting in a decline of over 1.3% to current levels. In comparison, the yield on ten-year U.S. Treasury notes, which are less under the control of the Federal Reserve, was as low at 0.50% during the year, and is currently around 0.90%. From March to June, when the markets were very unsettled and disorderly, rates on corporate and municipal bonds increased and spreads to U.S. Treasury securities widened substantially. However, all those yields collapsed during the summer, and most spreads to U.S. Treasury securities shrunk also. Today, municipal bond yields, both tax exempt and taxable, are below 1% out to five years. In this kind of environment, we tend to invest in short maturities for new bond purchases and do not take the risk of longer securities unless the investor is sufficiently compensated for the risk. Unfortunately, with such low yields, opportunities are limited, and fixed income securities serve primarily as portfolio stabilizers with very modest income produced.
"...with such low yields, opportunities are limited, and fixed income securities serve primarily as portfolio stabilizers with very modest income produced."
Given the growing amount of U.S. debt issuance and potential weakness in the U.S. dollar, one of our long-term concerns is the resurgence of inflation. The Federal Reserve has already indicated that it could tolerate inflation rates above 2% for a much longer period, as compared to the below 2% levels of inflation of the last 10 years. Would the Fed tolerate inflation levels of 3%? 4%? There are arguments for and against the likelihood of higher inflation. At Clifford Swan, we anticipate a higher inflation rate going forward, although the materialization of high inflation could be two to four years away. If a weakening of the U.S. dollar emerges, inflation could see a significant jump as imports escalate in price.
The environment we have described on the horizon for 2021 is largely one of rotation. We believe that in this environment our general focus on companies in growing markets, which includes growing revenues, cash flows, and earnings, should perform quite well. Our bottom-up, fundamental analysis allows us to identify good businesses at reasonable prices under varied economic conditions. We don’t chase stocks or look for the hottest tech stocks. Our priority is wealth preservation, which we believe is best achieved by owning high quality, predictable businesses.
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.