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FEG 2021 Investment Outlook


Promise or Purgatory?

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We are hopeful that 2021 becomes the year that we shed ourselves of COVID-19 and begin to unleash the promise of the economy’s potential. However, we know that there is still a long, wintery road to travel to recovery. With that in mind, we look at five questions that, we believe, may impact investments in 2021.

You can watch the webinar replay video here.

  1. What is the impact of a Biden administration?
  2. Do we see a cyclical rebound in 2021?
  3. How should investors approach technology and life sciences?
  4. How do you invest in fixed income with rates at 0%?
  5. Should investors be concerned about inflation?

What is the impact of a Biden administration?

Biden enters his presidency with a united Democratic Congress. However, the Democrats’ majority is razor thin – the Senate is split 50-50 with Vice President Kamala Harris casting the tie-breaking vote – and that may temper some of Biden’s initiatives. We do not look at investing based on politics; however, we believe it is important to understand how regulations and initiatives may impact the economy at large. Below we look at the Biden tax plan, regulatory rules, and infrastructure.

Proposing Higher Taxes
Biden’s proposed taxation plan is the second largest in over 50 years and is intended to support the expended government spending of almost $8 trillion over the next ten years, continuing the trend of large federal budget deficits. Proposed spending increases are focused on entitlements, education, infrastructure and employment, and healthcare, which are expected to aid the economy depending on the degree to which the economy is running near potential.

Biden Tax increase plan

 

Deregulation Likely to Revert
The Trump administration pushed for a reduction in regulatory rules with what became the “one in, two out” policy, which required that for “incremental costs” resulting from new regulations, equivalent costs associated with two existing regulations must be repealed.

Declining Regulatory rules

 

“Cryptocurrencies are a concern.”  
            – Janet Yellen at the Senate Confirmation Hearing

We believe that expectations for a deregulatory environment to persist are unlikely. Indeed, we may even see more regulation, particularly in blockchain or big tech, over the next four years.1

Infrastructure Spending May Increase Under Biden
Federal infrastructure spending has been discussed for years; however, passing an infrastructure bill has been unsuccessful. Under Biden, infrastructure may accompany further economic stimulus.

Dedicated tower infrastructure and data center funds may provide compelling opportunities, in addition to strategies poised to benefit from renewable energy’s likely on- or near-shoring of critical supply chain inputs and renewable energy transmission.

Infrastrucutre Spending necessary

 

Do we see a cyclical rebound in 2021?

One clear economic takeaway from 2020 was that the pandemic impacted businesses and their respective sectors very differently. Not only have technology-related stocks dominated U.S. equity performance, but weakness has also been disparate, with many cyclical sectors suffering the worst declines in earnings.

Earnings Estimates are Near or Better than Peak in some Sectors


Small Cap Equities Stimulus Boost
Many small cap stocks have negative earnings regardless of the health of the economy, but economic weakness tends to increase this population.

Stimulus or improvements in economic conditions that allow weak small cap stocks to survive often lead to outperformance of weaker companies. This was witnessed in 2020.

With improvements in economic conditions only partially improved, further progress may aid small cap equities.

Negative Earning Stocks Rallied with Stimulus

 

How should investors approach technology and life sciences?

As we mentioned in the question on cyclical rebound, technology-related stocks dominated U.S. equity performance. COVID-19 and work from home directives accelerated technology adoption in 2020 across industries, including education, healthcare, consumer, and logistics, among others.

A Bigger Opportunity Set for Tech and Healthcare Industries Within Private Equity
For those that have the capability and risk tolerance, private equity may offer a way to invest in technology and life sciences. In the Russell 3000 technology sector there are only 369 companies, whereas in private equity, 3,413 software and technology companies sold through acquisitions, initial public offerings, or were bought by larger private equity firms over the last five years.

US PE Exit Activity by sector

Private equity funds invest across the spectrum, from small venture capital funds to some of the largest private equity firms in the world focused on technology-related companies. 

Life Sciences Sector
Acquisitions of life science companies in pre-clinical companies rose from 6% in 2011 to 29% in 2020.

The time to exit has dropped from 4.2 years in 2015 to 2.9 years in 2019.

Scientific advancements in genomics, immunology, and other areas are creating a new wave of drugs coming through the approval pipeline.

Biopharma Investors are investing in opportunities at earlier stages


How do you invest in fixed income with rates at 0%?

With interest rates near all-time lows, high interest rate sensitivity – duration – in “core” fixed income presents risk to investors’ ability to preserve capital if rates rise. For investors wishing to protect against rising rates, they can mitigate rate risk by reallocating core fixed income assets into strategies managed against the intermediate aggregate index, with only a marginal decline in yield.

Conversely, duration in the realm of declining rates is often one of the most effective diversifiers of equity risk. Reducing duration also reduces the effectiveness of this equity risk mitigator.

Core Bond Duration risk has been increasing, while intermediate has been stable

 

High Yield is Priced as if the Pandemic is Over
High yield bonds provide a yield under 4.5%, offering a very modest return for accepting credit risk.

Default rates appear to have peaked at a rate well below those of the Financial Crisis, due in part to the support of stimulus.

Recovery rates, however, have declined from the levels witnessed in the pre-pandemic healthy economy, when lowered underwriting standards elevated concerns about covenant-lite loans.

High Yield Spreads

 

Structured Credit Is a Different Story
Structured credit markets experienced greater liquidity pressures than corporate markets in March, as levered buyers were forced by their counterparties to sell collateral into a stressed market.

Demand has remained lower than that in other markets. Greater liquidity challenges, combined with limited Fed support relative to the corporate credit markets, has been slowing the return of liquidity to structured credit markets.

Commercial Mortgage-backed securities

 

Should investors be concerned about inflation?

Although stimulus and dollar weakness fuels further inflation risks, the pandemic has been strongly disinflationary, limiting expected 10-year inflation to tepid numbers despite the Fed’s willingness to let inflation run above its 2% target.

Inflation Forecasts have ticked up

 

IN CONCLUSION

We are hopeful that 2021 will be a year of promise. However, much depends on vaccine distribution and we recommend watching this progression closely.

WHAT IS THE IMPACT OF A BIDEN ADMINISTRATION?

  • We do not look at investing based on politics; however, we believe it is important to understand how regulations and policy initiatives may impact the economy at large.
  • Under a Biden administration we expect a stronger push into renewable energy, and anticipate higher government spending, as well as increased taxes.

DO WE SEE A CYCLICAL REBOUND IN 2021?

  • The pandemic impacted businesses and their respective sectors very differently. Not only have technology-related stocks dominated U.S. equity performance, but weakness has also been disparate, with many cyclical sectors suffering the worst declines in earnings.
  • Stimulus or improvements in economic conditions that allow weak small cap stocks to survive often lead to outperformance of weaker companies. This was witnessed in 2020. With improvements in economic conditions only partially improved, further progress may aid small cap equities.

HOW SHOULD INVESTORS APPROACH TECHNOLOGY AND LIFE SCIENCES?

  • For those with the ability to withstand illiquidity and a higher risk tolerance, private equity may be a feasible way to invest in technology and life sciences. Private equity funds invest across the spectrum, from small venture capital funds to some of the largest private equity firms in the world, all focused on technology-related companies.
  • Scientific advancements in genomics, immunology, and other areas are creating a new wave of drugs coming through the approval pipeline. Acquisitions of life science companies in pre-clinical companies rose from 6% in 2011 to 29% in 2020, and the time to exit has dropped from 4.2 years in 2015 to 2.9 years in 2019.

HOW SHOULD YOU INVEST IN FIXED INCOME WITH RATES AT 0%?

  • With interest rates near all-time lows, high interest rate sensitivity – duration – in core fixed income presents risk to investors’ ability to preserve capital if rates rise. For investors wishing to protect against rising rates, they can mitigate rate risk by reallocating core fixed income assets into strategies managed against the intermediate aggregate index, with only a marginal decline in yield. Conversely, duration in the realm of declining rates is often one of the most effective diversifiers of equity risk. Reducing duration also reduces the effectiveness of this equity risk mitigator.
  • Private debt yields tend to be “sticky,” and once or twice during the past decade, allocating to public high yield in lieu of private debt provided comparable yields. The opportunity favoring public high yield that developed during the initial onset of the pandemic evaporated quickly and private debt is more compelling.

SHOULD INVESTORS BE CONCERNED ABOUT INFLATION?

  • Although stimulus and dollar weakness fuels further inflation risks, the pandemic has been strongly disinflationary, limiting expected 10-year inflation to tepid numbers despite the Fed’s willingness to let inflation run above its 2% target.
  • While we may see a few inflation scares, we do not believe we will see sustained high inflation.

We encourage investors to consider their missions, unique investment needs and objectives, and current portfolio construction when evaluating the varied opportunities and risks available in today’s markets. What works for one, may not work for all.

 

FOOTNOTE:
https://www.wired.com/story/janet-yellen-consider-limiting-cryptocurrency/

 

DISCLOSURES:
This report was prepared by Fund Evaluation Group, LLC (FEG), a federally registered investment adviser under the Investment Advisers Act of 1940, as amended, providing non-discretionary and discretionary investment advice to its clients on an individual basis. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Fund Evaluation Group, LLC, Form ADV Part 2A & 2B can be obtained by written request directed to: Fund Evaluation Group, LLC, 201 East Fifth Street, Suite 1600, Cincinnati, OH 45202 Attention: Compliance Department.

The information herein was obtained from various sources. FEG does not guarantee the accuracy or completeness of such information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. FEG assumes no obligation to update this information, or to advise on further developments relating to it.

Index performance results do not represent any managed portfolio returns. An investor cannot invest directly in a presented index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown.

Neither the information nor any opinion expressed in this report constitutes an offer, or an invitation to make an offer, to buy or sell any securities.

Any return expectations provided are not intended as, and must not be regarded as, a representation, warranty or predication that the investment will achieve any particular rate of return over any particular time period or that investors will not incur losses.

Past performance is not indicative of future results.

Investments in private funds are speculative, involve a high degree of risk, and are designed for sophisticated investors.

This report is prepared for informational purposes only. It does not address specific investment objectives, or the financial situation and the particular needs of any person who may receive this report.

Diversification or Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment loss.

The Bloomberg Barclays Capital Aggregate Bond Index is a benchmark index made up of the Bloomberg Barclays Capital Government/Corporate Bond Index, Mortgage‐Backed Securities Index, and Asset‐Backed Securities Index, including securities that are of investment‐grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million.

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