As of 1/21/21, the CDC reported US COVID-19 (“COVID”) infections of approx. 24.1 million (209% increase from 3Q20) and deaths of approx. 400,000 (86% increase from 3Q20). I This represents approximately 25% of global infections, which stand at 97.3 million and 19% of global deaths, at 2.1 million. II Despite seeing some improvement to infection rates over the summer, as we headed into the winter a resurgence of cases caused the 7-day moving average for daily new infections and fatalities to hit new highs of approx. 200,000 and 2,000, respectively. IV
However, good news finally arrived in the fourth quarter, as two new vaccines were approved late in the year (Pfizer & Moderna). Although data will become more reliable as global vaccinations continue being administered, early results have demonstrated favorable efficacy rates of roughly 90%. VI While initial distribution efforts have sputtered somewhat, supply seems to be on target to provide vaccinations for as many as 150 million Americans by mid-year. IV Furthermore, six additional vaccines are currently in their final trial stages, which would substantially increase supply should they become viable. There are even some expectations that global supply could actually exceed demand by the end of 2021. Our economy has proven remarkably resilient in the face of an epic disruption, but the challenges posed by the pandemic remain daunting and are still expected to be the primary headwinds toward full economic recovery. The vaccine is a game changer, providing more hope and clarity for households, companies, and governments on getting to a post Covid-19 economy. But the pace and breadth of the recovery will likely be dependent on how efficiently we are able to inoculate the general public.
The Fed reacted to market volatility in February 2020 with a fast and aggressive policy response that started with the global financial crisis playbook and then went significantly further. These actions included cutting interest rates back to zero and initiating a fresh massive round of quantitative easing. Since the start of 2020, the Fed’s balance sheet has grown by nearly $3.2 trillion, including roughly $2.2 trillion in Treasury bond purchases. These actions were initially critical in stabilizing markets and addressing corporate liquidity demand resulting from COVID shutdowns. Furthermore, these actions signaled to the economy that the Fed stood ready to use its full arsenal of tools to help businesses survive the pandemic. As of 12/31/20, the Fed’s total balance sheet debt sat at roughly $7.2 trillion. V Although the Fed has substantially dialed back its purchases over the past two quarters, notes from the December FOMC meeting indicated its intention to continue these measures at a rate of at least $120 billion/month until “substantial further progress has been made towards the Committee’s maximum employment and price-stability goals.” III
In regards to the Fed’s second objective, inflation control, the massive stimulus we’ve seen has created a scenario that could potentially be problematic over the long-term, but is currently less concerning due to abnormally low inflation rates leading up to the recession. Coupled with a collapse in oil prices, resulting from historically low demand in 2Q20, inflation declined in 2Q20, with YoY change in the CPI falling as low as 0.2% in May (1.2% excluding food and energy). Since then, inflation has somewhat stabilized, with YoY CPI growth for December rising to 1.3% overall (1.7% excluding food and energy). IV
With inflation still well below the 2% target level, the Fed amended its prior position on interest rates. After slashing the federal funds rate down to the 0-0.25% range in March, the Fed announced in August that it would pursue a policy of “Average Inflation Targeting.” Essentially, this means that rather than raise interest rates once inflation hits the 2% target, it will look to maintain the current interest rate posture for a while after the target has been met until it appears inflation is on track to moderately exceed 2% going forward. While it is unknown when rates will eventually be increased again, the Fed has indicated it has no plans to increase them until 2023 and will likely wait until the U.S. Labor market achieves full employment before implementing any rate hikes. IV It is worth noting that while inflation typically troughs following the end of a recession, things may be a little different this time around. Specifically, the expectation for additional fiscal stimulus, coupled with higher operating costs associated with the pandemic, could potentially cause temporary inflationary upticks that are not necessarily reflective of the true economic reality on the ground.
Through measures like the CARES Act passed in March 2020, the Federal Government has provided financial relief in the form of loans to businesses and direct payments, forbearances, and enhanced unemployment subsidies to individuals. By the end of 3Q20, COVID-related fiscal stimulus totaled $2.4 trillion, representing approximately 11.8% of GDP, more than double the 2009 stimulus package. VIII However, since that initial push, further relief efforts stalled due to fierce political posturing leading up to the election. Finally, at the end of December, congress approved the Consolidations Appropriations Act, a 2nd package of $900B in additional emergency fiscal stimulus to provide support to counter pandemic-limited economic activity. This included direct payments, more unemployment insurance, rental assistance, and additional funding for business loans. Now, with Democrats gaining control of all three houses, expectations are that additional fiscal stimulus will begin rolling out of Washington shortly. Most recently, the Biden Administration has put a $1.9 trillion package on the table, which provides further relief for small businesses, local and state governments, as well as direct payments of approx. $1400/person. While nothing has been finalized, it is likely that the new administration will probably err on the side of short-term relief versus long-term balance sheet normalization.
At the regional level, state and city governments have been decimated by the pandemic. The combination of tax revenue shortfalls (due to business closures) and the spike in unemployment obligations, has squeezed these budgets to their max. Should unemployment remain high for an extended period of time, the tax base of many municipalities can be expected to continue eroding, creating significant drag on recovery prospects at large, as state and local governments employ roughly 20 million Americans. VI As such, it is becoming more crucial that these entities are included in future fiscal stimulus packages to ensure their capacity to meet financial obligations without being forced to impose deep spending cuts to their respective workforces. Early indications out of Washington are that funds for state and local governments will indeed be included in the upcoming stimulus.
Of course, further fiscal stimulus, regardless of necessity, is not without complications and consequences. Federal debt, already trending at uncharacteristically high rates due to the 2018 tax cuts and pre-COVID government spending increases, skyrocketed further following the first stimulus package in March, and finished 2020 at 100.1% of GDP. With nearly $22.5 trillion of debt outstanding currently, the CBO projects this number to increase to nearly 110% of GDP by the end of 2021. VI When government debt reaches these levels, corrective measures must be taken to avoid long-term inflationary risks, typically in the form of tax increases. While future tax increases have been on our radar for quite some time, the pandemic and resulting stimulus, has certainly exacerbated this trend. Gradual tax increases over many years can be more easily absorbed by a growing economy and are less likely to cause material disruptions. Perhaps more relevant to our current situation is whether or not a more pronounced shift in tax policy from the Biden Administration is on the near-term horizon, and what impact such changes might have on the economic recovery. Although Biden campaigned on an economic platform that incorporated tax increases on corporations and high-income earners, a slim majority in the Senate would likely require some watering down of any tax bill hoping to get past the filibuster. Furthermore, it seems unlikely that such policies would be implemented before an economic recovery is more meaningfully realized.
After a horrific 2Q20 that saw GDP growth decline by -31.4%, U.S. GDP rebounded sharply in the 3rd quarter finishing up 33.4%, and far exceeding initial expectations of 19%. IV The double-dip recession, that so many feared never arrived, and it doesn’t appear like it will happen in early 2021 either. The faster than expected recovery has been primarily due to the resilience of domestic households and businesses, both of which found new and innovative ways to address consumption and productivity needs in the face of extremely challenging circumstances. However, despite a strong rebound from the trough of March and April, growth did decelerate in Q4, due largely to renewed shutdowns going into the winter and is expected to be approx. 5% for the quarter and down -2% to -4% overall for 2020.
Going into 2021, quarterly growth is expected to be in the low single-digits, though we believe a full recovery will likely not be achieved until industries most directly impacted by the pandemic (airline, restaurant, and hospitalities) are able to return to pre-pandemic levels. Assuming vaccination distribution improves, and herd immunity is achieved, YoY GDP growth could reach high-single digits by the end of 2021, before returning to a more normalized growth rate of 2.0-2.5% in 2022. IV
Corporate earnings improved substantially in the second half of 2020, after experiencing quarterly declines in Q1 of -49% and Q2 of -33%. Although still negative, Q3 declined by only -5% and Q4 is estimated at -7%. The sharp turnaround is encouraging and indicates that earnings are poised to hit new all-time highs in 2021. V Earnings estimates were revised higher during the second half of 2020, aided by vaccine-related optimism, and as of 12/31/20, they were expected to finish the year down between -12% to -15% YoY.
Of course, the rebound has not been evenly felt across industries. In particular, companies with fast and efficient online business models are soaring above the terrestrial competition, disrupting the status quo and displacing old-economy stalwarts. IX In 2020, E-commerce grew more in just one year than it had the previous ten years combined, accounting for 16% of total U.S. retail sales by year-end. VII Technology, communications, health care and consumer staples have all seen earnings recover to near pre-COVID levels, with many companies seeing even stronger revenues than before the pandemic. This success is largely due to the ability to adapt to the “new normal” by pivoting to E-commerce solutions and innovating production and service capabilities. On the flipside, the airline, restaurant, and hospitality industries were decimated by the shutdown and have still yet to experience any meaningful rebound since economies reopened. For all intents and purposes, these industries remain relatively “closed” due to their dependency on in-person business operations, which have been substantially limited by public health restrictions. It is unlikely that these sectors will see sizeable recovery until said restrictions are lifted, which isn’t expected to occur until a critical mass of the general public is vaccinated (possibly 4Q21).
In the United States consumption is by far the largest component of GDP, accounting for roughly 70%. As such, consumer spending will continue to serve as a critical driver of economic growth and the most important variable in determining the length and scope of the recession. Consumer confidence plunged in March and April as 22M people lost their jobs. But confidence stabilized quickly, has improved considerably, and remains well above the levels of the last recession. As the vaccine rollout continues, we expect confidence to continue to increase. Buoyed largely by government stimulus, favorable consumer savings rates early in the recession provided a long runway for pent-up demand once economies reopened. As of November, the personal consumer savings rates stood at 13.6%, which is relatively strong considering economic headwinds. VI However, this represents a substantial drop-off from Q1, when the savings rate exceeded 30%. At the current burn rate, it seems unlikely that consumer spending will be able to continue powering the recovery without additional fiscal relief.
After shedding 22.1 million jobs between February and April, the labor market recovered 58% of those losses from April to November. IV The job recovery coming out of the lockdown has occurred at a much faster clip than previously anticipated, as unemployment finished the year at 6.7%, no small feat after hitting an 80-year high of 14.7%, back in April. X While the partial recovery has occurred more rapidly than expected, the pace has slowed substantially in 4Q20. After 7 consecutive months of job gains, December reported net job losses of approx. 140,000. Specifically, leisure and hospitality jobs contracted by 498,000 for the month impacted by many renewed COVID restrictions.
Although headline employment data appears to be rapidly moving in the right direction, a deeper dive reveals that employment trends may not actually be as robust as the numbers imply. Notably, the majority of employment gains have come from temporary workers, while permanent unemployment has actually increased by 2.1 million since the recession began. X In general, unemployment is a lagging indicator, as the rehiring of permanent positions doesn’t typically occur until after companies have regained their financial footing following a recession. However, with many temporary business closures increasingly becoming permanent, more meaningful employment gains are unlikely to occur until some of the hardest hit industries (airlines, hospitality, travel, energy) are able to join the larger recovery and begin their reopening processes.
If we would have told you on January 1st of 2020 that 92% of the global economy would completely shut down in three months-time, you probably would have moved all of your money to cash and hunkered down, hiding your assets under the mattress until the dust settled. Of course, if you did that you would have also missed a tremendous year for equity returns. Despite unprecedented economic headwinds caused by a once in a century pandemic, global equities extended their rally in Q4 for the third quarter in a row, leading to impressive, above-average returns for the year. Compared with other recessionary selloffs, 2020 marked the swiftest market drop (-34% in 23 days) and the quickest, sharpest bounce back, fully recovering losses in only 22 weeks. Positive vaccine developments and expectations for a full economic reopening in 2021 generated a reflationary trade in Q4. The S&P 500 finished the year up an astonishing 18.4% (nearly 2x its 15-year average), routinely setting new highs along the way. This unprecedented market run-up has primarily been driven by historically dovish monetary and fiscal stimulus, as well as the emergence of mega-cap tech companies. For perspective, the top five S&P 500 companies (all mega-tech), accounting for 22% of the index’s market capitalization, saw their equity shares grow 49% in 2020, while the remaining companies combined for an annual return of just 9%. VII
Looking deeper into the numbers, growth stocks, fueled by mega-cap tech stocks, were the star performers, up 38.3% for the year. Online retail and tech stocks led the way, finishing the year with gains of 69% and 44%, respectively. Small caps poised an impressive comeback in Q4, causing them to outperform large caps for the year, up 20% in 2020. Value stocks lagged considerably, but staged a remarkable comeback in Q4, landing in positive territory for the year, up 2.9%. Among the biggest losers, energy stocks finished the year down -34%, while the airline and hospitality sectors followed close behind down -31% and -26% for the year. V
While the investment community is largely pleased that equities came roaring back, following the massive sell-off in March, this remarkable feat is not without caveats. A bullish reversal in market sentiment, combined with easy monetary policies and depressed earnings, have driven global valuations to decade highs. As of 12/31/20, the average forward P/E ratio for the S&P 500 was 22.3x, substantially higher than the 25-year average of 16.5x. V
International equities also performed well in 2020 with the MSCI All Country World Index (ex-US) finishing the year up 10.7% (roughly double its average return over the last 15 years). Emerging Markets flew under the radar and surprised investors with an impressive gain of 18.3% for the year vs. developed markets up only 7.8%. Within these numbers it’s worth noting that Chinese equities were by far the biggest winners, gaining 29.7% in 2020. Despite international equities performing quite well last year, when compared to domestic markets, international stocks remain relatively cheaper with somewhat less swollen valuations.
Fixed income securities performed surprisingly well in 2020 and continued to move higher in the 4th quarter, with gains in almost every sector. However, favorable returns were largely due to price appreciation as yields and spreads have dropped dramatically and remain historically low. The interest rate landscape was radically altered in 2020 by deflationary pressures related to slower global growth, aggressive rate cuts by the Fed, and new quantitative easing measures. This pushed bond yields to record lows, with the 10-year Treasury yield falling below 1% for the first time ever in March and finishing the year at a mere 0.93%. While the Barclays Aggregate Bond Index returned 7.5% for the year, the yield was only 1.12%.
Riskier categories, such as high yield bonds, emerging market debt, and leveraged loans posted solid returns in Q4 amid monetary support and continued economic progress, pushing them all into positive territory for the year. High yield securities, which were hit the hardest by the economic shutdown and liquidity crunch in March and April, made an impressive comeback in Q4, ending the year with gains of 6.2%. Municipals also had a strong 4th quarter bringing annual returns to 5.2%. There is, however, cause for concern in this sector as fundamentals for municipalities have deteriorated and pandemic shutdowns have put extreme pressure on state and city budgets.
The Fed has made it clear that even if jobless rates improve, they are committed to keeping interest rates at current levels until at least 2023. As such, it will be difficult, near impossible, for income investors to generate meaningful yields from traditional fixed income investments. Additionally, the interest rate risk of holding traditional bonds may not be worth the reward. A modest rise in interest rates could imply a significant decline in price that would likely offset income gains. Investors will be forced to look beyond public bonds for alternative sources of income, in sectors such as private credit or direct real estate.
Although COVID headwinds are still very much in play for 2021, the release of two high-efficacy vaccines, and the possibility of as many as six more on the way, provides optimism that the recession’s worst is likely behind us. Although recovery prospects for 2021 remain strong, with higher asset valuations already reflecting positive expectations for reopening, financial markets are likely to be influenced heavily by the trajectory of policy, inflation, real interest rates, and the vaccine rollout. Continued market volatility is likely. Additionally, as we anticipate the low-interest rate environment to continue for at least a couple years, fixed income investors will be hard pressed to generate meaningful yield from traditional fixed income securities alone.
With this in mind, we encourage short-term and conservative investors to consider working with their advisors to identify alternative strategies to help with providing true downside protection. For income seeking investors, Private Credit funds or Direct Real Estate Funds may potentially provide meaningful income and inflation protection in the near to medium-term. For aggressive, long-term investors, despite much uncertainty regarding the pace and scope of economic recovery, we encourage a disciplined dollar-cost-averaging strategy and would recommend avoiding the potential “bail out” mentality in the face of any unanticipated market corrections. As always, we strongly encourage you to connect with your fiduciary advisor to ensure your current investment strategy is in line with your risk tolerance, need for liquidity and short term/long term goals.
Chief Investment Officer
|Andrew Mescon, MBA
VP of Strategy
IV. P. Morgan – Economic and Market Update 1Q21 (12/31/20)
V. P. Morgan – Guide to the Markets 1Q21
VI. FS Investments – 10 for ’21 (11/30/20)
VII. Goldman Sachs – Market Pulse Special Edition: 10 for 21 (12/2020)
VIII. U.S. Department of Treasury, Congressional Budget Office
IX. Capital Group – Outlook January 2021
Disclosure: Past performance is not indicative of future results. The opinions expressed are those of the Integrity Financial Corporation (“Integrity”) and should not be taken as financial advice or a recommendation to buy or sell any security. Integrity is a registered investment adviser. Registration does not imply a certain level of skill or training. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Past performance is not indicative of future results. Investing involves the risk of loss of principal. Investors should ensure that they obtain all current available information before making any investment. Indices cited in the information above are intended to support the opinions expressed and are shown as general examples of market trends. It is not possible to invest directly in an index and the volatility of the index may vary from that of an investor’s actual account. Note that index performance shown does not take into account management fees and is not intended to be indicative of future results. Additional information about our investment strategies, risks, fees, and objectives can be found in Integrity’s Form ADV Part 2. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. There is no guarantee of the future performance of any Integrity Financial portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies.