In a sharp contrast to the immense growth headwinds in 2020 fueled by the outbreak of COVID-19, most major asset classes and categories posted strong calendar year gains, following broad-based gains in 2019 and providing a much-needed silver lining in what proved to be one of the most somber and volatile years in recent memory. As anticipated, the geopolitical landscape demanded the complete attention of asset allocators, particularly related to COVID-19’s impact on global economic growth trends, the associated responses by global policymakers, the November U.S. presidential election, and the resultant trajectory of the domestic economy under a Democrat-controlled presidential administration and Congress.
To begin 2021, congressional confirmation of the electoral process formalizing Joe Biden as the president-elect, along with a Democratic sweep of Georgia’s Senate runoff race have potentially cemented Democrats’ control over the direction of critical fiscal policies at the forefront of the ongoing economic rebound, as well as other key policy initiatives spanning immigration, healthcare, education, and foreign policy. With the newly split Senate, Vice President elect Kamala Harris’s tie-breaking vote could pave the way for a relatively frictionless near-term path for the implementation of Democrat-based policies, although a split Senate and a marginal Democratic lead in the House would likely require near-unanimous support for the passage of legislation.
On the performance front, global equities tumbled in March, suffering through the sharpest and deepest drawdown since the 2008–2009 Global Financial Crisis. The introduction of unprecedented levels of monetary and fiscal stimulus by global policymakers helped reverse the decline across risky assets and propelled most major global equity indices to fresh record highs by year-end. Statistically, the higher-quality growth segment, which contains a disproportionately large weighting in the information technology sector, strongly outperformed the more cyclically oriented value area of the market, which faced headwinds amid record low interest rates, shallow yield curve slopes, and elevated downside volatility in crude oil prices. Large cap performance generally overwhelmed small cap throughout most of the year, however, a strong fourth quarter risk-on rally pushed small cap slightly ahead of large for the calendar year. A similar theme materialized in regional relative performance, with emerging market equities nearly matching the calendar year performance generated by domestic markets, despite lagging for the duration of 2020.
Fixed income markets were similarly exciting, with high yield spreads widening to 1,100 basis points over Treasuries during the brief liquidation across risky assets in March, before tightening sharply to below historical averages by year-end. Nominal Treasury interest rates established a new record low of 0.51% in early August, and real interest rates (TIPS yields) spent the lion’s share of 2020 deep in negative territory, providing support along the way to both elevated equity valuations and zero-yielding monetary assets such as precious metals.
On balance, real assets performance was negative throughout 2020, particularly among the more growth-sensitive assets such as energy-related sectors. REITs suffered against the backdrop of large-scale, work-from-home orders; shutdown-triggered weakness among hotel, retail, lodging, and other sectors; and the weakest labor market backdrop in at least 50 years. More recently, inflation-sensitive sectors have garnered attention from asset allocators amid prospects for positive inflation surprises following the rollout of a COVID-19 vaccine and the restart of the global growth engine.
KEY MARKET THEMES AND DEVELOPMENTS
Policymakers Spring to Action Amid Severe COVID-19 Growth Pressures
Front and center among the abundance of market-moving macro-related events in 2020 was the global spread of COVID-19, which, at last count, had infected more than 90 million people across the world, with nearly two million fatalities registered.
Recent positive developments have surfaced on the vaccine front, with multiple vaccines in the initial stages of deployment across many of the world’s major economies. A new “super strain” of COVID, however, remains one of many unknowns facing investors in the new year.
Policymakers were eager to devise and implement ultra-stimulative monetary and fiscal initiatives throughout 2020, particularly during the first half of the year when COVID-19 lockdown measures ground much of the economy to a halt. In the first quarter of 2020, real gross domestic product (GDP) growth declined 5.0% quarter-over-quarter, followed by a severe 31.4% annualized quarterly decline in the second quarter amid the implementation of nationwide containment measures. The slump that occurred in the second quarter proved to be the most severe since at least 1947, when modern records of quarterly GDP growth began.
In the U.S., the Federal Reserve (Fed) lowered the federal funds rate back to the zero-bound, initiated a new quantitative easing (QE) program, established numerous special purpose vehicles to supply liquidity to certain sectors of the U.S. bond market, and provided forward guidance for low rates into 2023, among other accommodative actions. By year-end, the Fed’s balance sheet had expanded a staggering $3.2 trillion year-over-year, ending 2020 at $7.36 trillion.
On the fiscal front, Congress passed two separate stimulus packages in 2020, the first in March worth $2.2 trillion and the second in December at $900 billion, with direct checks going to millions of Americans as part of both deals. These stimulative fiscal programs—in conjunction with a sharp drop off in economic activity—drove the budget deficit-to-GDP ratio above 15% during the year, the highest level on record dating back to the late 1960s. When viewed through the lens of the year-over-year change in the Fed’s balance sheet and the federal budget deficit, policy accommodation throughout 2020 appears to have totaled at least $6 trillion.
Provided the vaccine rollout is successful and recent positive developments on the COVID-19 front continue, pressure may fall on the Fed in the quarters ahead to move market expectations in the direction of relatively tighter monetary conditions, particularly should the recent increase in inflationary sentiment materialize in positive inflation surprises. However, the Fed is likely to exhibit extreme caution against the backdrop of record-high price and valuation levels, especially if their inflation bogey remains below the 2% targeted threshold, a metric which had already appeared to be in secular decline pre-COVID-19.
Liquidity-Induced Rally Sends Global Equity Indices to new Highs, Credit Spreads to Below Averages
A byproduct of the injection of massive amounts of liquidity into the financial system by policymakers in an effort to cushion the financial markets and broader economy from the shock of COVID-19 has included an apparent melt-up in risky asset prices. On the domestic equity front, the major indices registered new record price levels, with valuations exhibiting similar strong upward bias.
The combination of Fed asset purchases across Treasuries and agency mortgages that helped drive nominal interest rates lower across these respective sectors, with congressional support of loose fiscal policy, and record-low, risk-free rates has potentially placed equity markers into the “melt-up” phase, in which record-high price and valuation levels ultimately revert to more normalized levels, provided a catalyst for change is introduced.
In a new twist on the Fed’s support for the free flow of liquidity in the U.S. bond market, 2020 saw the Fed establish multiple special purpose vehicles (SPVs) aimed at supplying the bond market with much-needed liquidity, including both investment and below-investment grade municipal and corporate bonds. The mere establishment of these entities appeared to have stopped the widening in credit risk premiums in its tracks, as high yield spreads blew out to greater than 1,000 basis points over Treasuries in March, before hastily tightening below historical averages following the Fed’s historic moves.
Once the effects of the deluge of liquidity begin to fade, asset allocators may be confronted with a severe conundrum, as both high-quality fixed income valuations and risky asset valuations generally appear over-extended, due in large part to the Fed’s backstopping of the drawdown potential among major domestic risky asset categories. While continued positive developments around COVID-19 are undoubtedly welcomed, the discounting process of incrementally less accommodative policies may prove painful to certain corners of the market.
“Reflation Trade” Gaining Traction, but Facing Meaningful Secular Headwinds
Similar to the sentiment surrounding the ultra-stimulative policy efforts set forth by the Fed in the midst of the 2008-2009 Global Financial Crisis, today’s market environment has resulted in an increase in sentiment for near-term positive inflation surprises. After all, with realized annual inflation levels across the major price indices running materially below 2%, the “bar” for positive inflation surprises remains low. Nevertheless, sentiment has certainly shifted in recent months in favor of higher near-term inflation rates, some of which is likely attributable to the recent increase in crude oil prices and a surge in growth across the U.S. money stock.
The Treasury market’s implied expectation for realized inflation over the coming 10-year horizon, that is, the yield spread between the nominal 10-year Treasury note and 10-year TIPS, sank to just north of 0.50% during the depths of the equity drawdown in March 2020, before concluding the year at 1.97%, essentially right on top of the Fed’s 2.0% targeted inflation level.
The recent increase in inflationary expectations is likely a welcomed development by the Fed, which, should it result in an increase in actual inflation, would give the central bank increased space to maneuver the near-term policy landscape.
However, counterbalancing forces weighing on a persistent rise in inflation remain abundant, including a historically low birth rate, an aging demographic, persistently wide budget deficits, a secular rise in the country’s debt burden, a steep drop-off in money velocity, which measures the efficacy of changes in the money stock (denominator) on changes in economic activity (GDP and the numerator), and, most notably, a sub-1% annual population growth rate. This ratio is often a proxy for the rate of turnover in liquidity within the financial system and is typically viewed as a key ingredient in the potential for destabilizing inflationary pressures.
Despite Easiest Financial Conditions on Record, Economic Data Has Recently Lost Traction
By the time 2020 came to a close, policymakers appeared to have been successful in their efforts to ease financial and business conditions, a key pillar in the healthy functioning of the market’s internals. Certain measures of broad financial conditions—which include factors such as the exchange rate, yields on riskless assets, credit spreads, and equity valuations—have eased to historically loose levels. Goldman Sachs’ U.S. Financial Conditions Index, for example, has improved to suggest the easiest set of financial conditions in the history of the data series.
If the easing of financial conditions to historically loose levels was a key factor in the market’s historic rebound since March, it stands to reason that an eventual tightening of standards could send volatility levels meaningfully higher across the performance of both major asset classes and economic aggregates.
Recent labor market trends suggest the improvement across economic fundamentals may already be in the process of stalling, as payroll growth has lost meaningful traction in recent months. In December, for example, both the Bureau of Labor Statistics (BLS) and Automatic Data Processing (ADP) reported a net loss in jobs during the month, the first negative job report since exiting the initial COVID-19 lockdown period.
Sell-side estimates for first quarter GDP growth have also soured in recent months, with the Bloomberg median sell-side estimate halving since last summer to reflect a 2.5% anticipated real GDP (annualized) growth rate in the first quarter of 2021.
While a necessary response, vast intervention efforts by policymakers in 2020 amid the sizable growth headwinds presented by COVID-19 have resulted in a potentially destabilizing set of conditions. These include absolute interest rate levels slightly north of historical lows, credit spread levels well below historical norms, equity valuations at or near extreme highs, and financial conditions the loosest in modern records. Active investment managers who thrive in a diverse market environment—a central focus of FEG’s investment process—appear to be in a favorable position entering 2021, following an eventful and fruitful 2020.
Outlook and Concluding Thoughts
The global outbreak of COVID-19 accelerated the already ongoing global, economic slowdown throughout 2020, as most major economies entered the year with economic growth rates grinding to a halt amid previous trade war tensions and an aging business cycle. Policymakers were quick to introduce and implement creative stimulative measures which, on the surface, helped plug the initial demand gap driven by COVID-19’s spread.
Byproducts of the simulative efforts set forth by global policy-setting authorities included a historic rebound across the major global equity indices, including the establishment of record-high price and—in some areas—record-high valuation levels, in turn resulting in meaningful downward revisions for the total return potential across most major risky asset categories over the cyclical horizon, absent a shift in market conditions.
Moreover, investor sentiment surrounding the risk of positive inflation surprises has percolated, driven by a surge in money supply growth, an expansion of post-2008 experimental monetary initiatives, and material calendar-year depreciation in the U.S. dollar. Secular headwinds in the way of an aging demographic, a massive debt build-up, the proliferation of entitlement-based policies at the expense of investment-oriented programs, and sub-1% population growth could weigh on persistent increases in realized inflation, without a regime shift.
A pillar of FEG’s research and investment processes includes a disproportionate emphasis on active managers who possess proven track records among numerous market cycles and geopolitical backdrops. On balance, 2020 proved prosperous for many of FEG’s recommended managers and client portfolios, with increased dispersion amid a market backdrop which sadly—yet thankfully—provided abundant opportunities to add value throughout the year. We believe the coming year is poised to usher in a more favorable overall climate, particularly from a societal standpoint, with hopes for a continued silver lining in the form of a favorable investing environment.
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Diversification or Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment loss.
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Published January 2021
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