Economic & Financial Market Outlook - Winter 2021

2020 is now, thankfully, history. While the human toll from COVID-19 has been staggering, the economic damage has not been as great as initially feared. The Federal Reserve now forecasts that full year 2020 GDP will have declined by 2.4% from 2019 , less than the drop in 2008 during the Great Recession. The initial estimate at the start of the pandemic was for a decrease closer to 5%. Of course, to keep things in perspective, a deeper slump was only averted by an increase in Federal government spending of approximately 40% accompanied by the Federal Reserve adding trillions into the financial system.

2020 GDP gyrated wildly from quarter to quarter. GDP plummeted at an annualized 31% rate in Q2 on the shutdown, only to roar back at a 34% pace in Q3 . As for Q4, growth has obviously slowed. The resurgence of COVID-19 cases put a damper on activity. Additionally, a follow-on relief package did not materialize until year-end after many support programs had already expired. A wide range of estimates exist for Q4 GDP. The well-regarded GDP tracker, produced by the Atlanta Fed, pegs Q4 GDP at a still blistering 9%, but most estimates are considerably lower, coalescing at 4.5% , which is impressive all the same given the headwinds.

The outlook for 2021 is encouraging. The Federal Reserve upgraded its projection to 4.2% in December from 4.0% in September. Q1 GDP will continue to be hampered by the burgeoning rate of COVID-19 infections, but the additional $900 billion in additional COVID-19 relief should ensure that GDP remains in the plus column with the consensus at 2.5% . Widespread vaccination over the course of the first half of 2021 should result in a reacceleration of growth. The incoming Biden Administration is likely to seek additional stimulus, as well.

A continuation of easy monetary policy for 2021, however, seems a near certainty. We have noted previously that the Federal Reserve’s top priority is restoring lost jobs. While the recovery in the labor market has been impressive, unemployment sat at 6.7% in December versus 3.5% pre-COVID-19 . Fed projections place the long-term rate of unemployment at 4.1%, while the 2021 year-end rate is forecasted at 5.0% . There is still considerable room before concern mounts at the Fed over inflation from labor shortages. Financial conditions are thus likely to remain supportive of growth throughout the year.

The composition of growth in 2021 is less clear. Residential construction proved to be a boon in 2020, as were consumer durables, generally. Housing affordability is now somewhat stretched. There is some expectation that consumer spending could shift towards experiential services, such as travel and dining out, as opposed to the purchases of goods. Municipalities are also clamoring for additional Federal assistance. Without it, government layoffs at the local level could persist. The acceleration of trends including work from home, online commerce, and robotics may be irreversible. While all may help achieve greater productivity, their impact on the labor market and real estate sector remains to be seen.

Overall, the U.S. economy demonstrated considerable resilience in 2020. We expect it will cope well with these shifts in 2021. Given that a synchronized global recovery is likely after a rare outright decline in global GDP, our base case is that the U.S. should enjoy solid growth in the year ahead and return to a stable growth path.

2020 financial markets were a rare bright spot in a generally depressing year. The late Winter COVID-19 induced bear market was the shortest on record as governments and central banks responded forcefully to blunt the economic impact of the pandemic. In the U.S., Congress swiftly passed a $2.2 trillion relief package; the CARES Act, which provided assistance to businesses and individuals. Personal income was not just supported but boosted as $1,200 checks were sent to most taxpayers and generous unemployment benefits were instituted temporarily. The Federal Reserve cut the overnight rate to the zero-lower bound, reinstituted quantitative easing on a massive scale, and took unprecedented steps to shore up credit markets.

Investors responded enthusiastically, driving outsized returns in both stock and bond markets. For the year-ended December 31, 2020, the S&P 500 Index returned 18.4% while the Bloomberg Barclays Aggregate Index tacked on 7.5% . As the year progressed, an “everything rally” took shape, with the vast majority of asset classes including commodities and currencies participating.

While we are optimistic on prospects for a return to sustainable economic growth by the second half of 2021, the financial market outlook is somewhat murkier. As noted above, Federal Reserve actions were key in reassuring investors. The Fed engineered a decline in rates and bond yields to record lows which served to push investors further out on the risk spectrum. Equities and lower quality debt were snapped up as government securities no longer provided a meaningful return.

As a result, valuations for both stocks and bonds are extremely elevated. S&P 500 Index earnings decreased by 17% in 2020 to an estimated $135 per share. We forecast that earnings will snap back 22% in 2021 to $165 per share, roughly the same level as 2019 . However, the S&P 500 Index ended 2020 at a price of $3,756, 16% higher than at year-end 2019 and 50% above the level at December 31, 2018 which is perhaps a more relevant date for comparison since we are looking at forward not trailing earnings. The benchmark’s current price/earnings ratio on 2021 earnings is a lofty 22.6x versus a historical average of 16x forward earnings.

The intent of the above discussion is not to declare equities wildly overvalued but to emphasize the importance of interest rates in driving returns. During the same two-year period as stocks surged while earnings sagged, the yield on the 10-year Treasury note declined 66% from 2.69% at year-end 2018 to 0.92% on December 31, 2020 . In short, falling interest rates were the lever to push stocks higher on the expansion of the price/earnings multiple rather than the lever of earnings growth.

In fact, we continue to find stocks relatively attractive compared to bonds. For now, at least, the Federal Reserve appears to have investors’ backs. The overnight Federal Funds rate will remain anchored near zero for a period of years, not months. Our expectation is that the Fed will continue to aggressively inject liquidity into the system via purchases of longer-term Treasury and mortgage-backed securities at least for the duration of 2021 before dialing back. This activity will restrain bond yields despite potential blips in inflation as a result of supply bottlenecks due to the full reopening of the economy.

In order to pursue its full employment mandate, we suspect the Fed will attempt to maintain negative inflation-adjusted (or real) interest rates across the yield curve. For that reason, investors may wish to adopt a multi-asset class approach to generate income. Shares of companies that can grow both earnings and dividends may offer part of the solution.

Financial market returns along the lines of 2019 and 2020 are unlikely in 2021. Bond yields have already seen the bottom, which will inhibit fixed income returns. A very small subset of mega-cap tech stocks led the equity market for the past two years which could leave the major indexes vulnerable to correction. Therefore, diversification may be increasingly important. Irrespective of market returns, 2021 should a much better year and we wish our clients a prosperous and, more importantly, healthy New Year.

Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results and the opinions presented cannot be viewed as an indicator of future performance. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Please consult with your Portfolio Manager, Financial Counselor, attorney or tax professional regarding your specific investment, legal or tax situation.

2021-02 (01/19/20)