Annus Horribilis: The End of Times, and a Cracking Good Year
“Thank God it’s over” was undoubtedly a familiar refrain at year-end gatherings (all socially distanced, of course, via Zoom). Surely 2020 will go down in the history books as one not to be repeated. It started with the impeachment of an American president, followed by a global pandemic that infected tens of millions and is on track to kill more than 1.6 million at last count,1 and was then accompanied by a global recession and resulting bear market reminiscent of the Great Financial Crisis. Finally, were this not enough for the stoutest of heart, a level of social unrest took hold across the country that harkened back to the protests of the late 1960s. This all unfolded against the backdrop of a presidential election contentious enough to hear fears of civil conflict openly discussed. It is hard to imagine another year in recent times that approached the dystopian atmospherics that plagued 2020. Yet, despite all of this, markets ended the year remarkably higher, which is a testament to the promise of science and the innate human tendency to believe that everything will work out in the end.
The Initial Shock Wave
A remarkable aspect of the year was how quickly things changed: a near-total shutdown of the commercial lives of countries across the globe, new forms of social interactions that involve staying six feet apart, wearing masks, and using so much hand sanitizer that we have become a nation of chapped hands. Exogenous shocks, an economist’s term to describe sudden disruptions to a system that originate outside of it, tend to accelerate trends already in place. To be sure, the pandemic has hastened changes in work arrangements that were in train for years. The “office-hoteling/hot desk” phenomenon quickly morphed into WFH (Work from Home) or Work from Anywhere. WeWork, the darling of private equity investors and the disruptor of traditional office space quickly became yesterday’s news when the bedroom became the new office. Healthcare and education, two of the most change-resistant sectors, were forced to morph into virtual doctors’ offices and classrooms. Changes in the retail sector accelerated as social distancing and consumer wariness to rub elbows with fellow shoppers made brick and mortar retailing even more unappealing than it was already. In these and many other cases, there is no undo button that can reset to the status quo ante. These changes will endure in some form going forward.
The pandemic wrought significant damage to the economy in the first half of the year, with recovery in financial markets by mid-year. In the second quarter, global GDP dropped at a 24% annualized rate, adding to the 14% first quarter decline.2 Global equity markets dove 32% in March (down 21% for Q1) reflecting the economic devastation3 (Exhibit A). In the United States, second quarter GDP fell 31% while the S&P 500 Index plummeted more than 30% in March (Exhibit B).4 Peak to trough the S&P 500 drop was an eye-watering 34%, before recovering in the middle of the year.5 Job losses were catastrophic. More than 31 million jobs were lost from the end of February through the end of April.6 By the end of November, there were nine million fewer Americans working than at the start of the year.7 However, monthly employment gains averaging 1.57 million over the last six months are helping to repair the damage done.8
The double-barreled policy response of combining aggressive expansion of the Federal Reserve’s balance sheet and the fiscal stimulus passed by Congress established a firewall against the economic fires spreading across the country and through the capital markets. Like labor-induced amnesia, it is easy to forget the stress that the spring lockdowns thrust on markets from the vantage point of new market highs and recovering labor markets. Dollar shortages and forced liquidation of mortgage REITs wreaked havoc across the fixed income complex. Yield spreads, a measure of risk on investment-grade bonds and high-yield loans/bonds exploded to levels not seen since the Great Financial Crisis (Exhibit C).
Credit markets could only be described as disorderly, a term that strikes cold fear in the chest of seasoned investors. Thankfully, when it seemed it could not get worse, it didn’t. The aggressive and swift response from the fiscal and monetary organs of government proved a powerful tonic to investors and a recovery that incepted in April continues.
When looking back on a year such as 2020, it is natural to focus on all the terrible things that happened. Undoubtedly, it was an annus horribilis, or horrible year; however, it could also be considered annus mirabilis, or wonderful year, given where things landed. What follows are a few things that went right:
- A vaccine developed with record-breaking speed
- Muscular policy responses to staunch economic and market dislocations
- A recovery in the labor market and the larger economy
- A massive recovery in capital markets which pushed a number of markets to new highs
- Improvements in the use of technology and processes which are likely to provide enduring productivity benefits
As challenging as 2020 was, a number of good things happened, perhaps reflecting the idea that adversity breeds initiative by necessity. Yet, this all begs the question: “Where do we go from here?”
The Path Forward
Forecasting is a devilishly tricky exercise. It should always be done with a healthy dose of humility and awareness that the future should not be considered in the singular, but the plural, as many futures are possible. Furthermore, it is a mistake to think that a new year marks a break with the old. Time is a continuum and forecasting should reflect it.
Global economic activity should continue to recover. With a vaccine in the early stages of distribution, the first steps toward a return to a less restrictive form of daily living can begin. International Monetary Fund estimates 2021 global growth at 5.2%. For the developed world the estimates call for growth of 3.9% and for the developing world, 6.0%.9 Whether these numbers come to pass will be a function of how quickly vaccines can be distributed to countries across the globe. Not everyone has to be immunized immediately; rather the near-term goal is to immunize enough to create “herd immunity.” That number is somewhere on the order of 70% to 80% of the global population. Expect tussles over who is the first to get the vaccine followed by who pays. The logistical complexity and heft of this effort will be the modern equivalent to the Berlin Airlift.
For the U.S. economy, the consensus forecast for 2021 growth stands at 3.1%.10 We remain convinced the recovery in the economy will have a W-shaped path. The first V of the W is complete. The second V is in the process of forming. The latest stimulus package is arriving just in time, as economic activity appears to be slowing, relative to the rapid recovery in mid-2020. The slowing of job gains and the leveling off and, in some cases, drops in purchasing manager indexes suggest that economic activity is cooling and needs additional help if it is to sustain a path of recovery (Exhibit D). The W-shaped recovery is also predicated on a winter rise, or second wave, of infections. This is clearly unfolding, as infections have jumped since October. Several states have instituted new travel and quarantine restrictions as well as curfews to arrest the rise in cases.
Given these trends, a pause in growth seems probable. Unfortunately, the easy part of the recovery has likely occurred. Working through the dislocations the pandemic wrought will be slow and difficult. Large numbers of workers in the hospitality, retail, travel, and energy sectors who lost their jobs will find it difficult to re-enter their former industries as capacity shrunk while companies tried to right-size themselves for a different future.
Any discussion of markets should start with the price of money as it is the foundation from which all other prices draw reference. Interest rates and the yield curve represent both the price of money and the price of money through time. Given the uncertainty the pandemic has foisted upon the global landscape, it is hard to see how interest rates will rise in 2021. With the global stock of negatively-yielding debt again above $17 trillion and economic doubts rising with the daily case count of COVID infections, both investors and policymakers are signaling that interest rates will likely remain floor bound for the foreseeable future. There is no envy for the speechwriters at the Federal Reserve. They will have to find new ways of repeating the old mantra: “The future is unknown and worrisome and interest rates need to remain low.” However, interest rates will likely be range bound at low levels as investor worries wax and wane over stimulus-induced inflation and central bank money printing.
Fixed income markets offer little in the way of compensation for investors. Yields on investment-grade bonds and high-yield debt fell in 2020 thanks to a squashing of interest rates to bolster investor confidence. With inflation running at roughly 1.5%, the 1.89% yield to maturity of the investment-grade bond market offers thin protection against the dissipating effects of inflation.11 While high-yield bonds offer more yield at 5.11%, this may not be enough to compensate for the damage caused by the expected rise in defaults. Given the need for income, it is hard to see how investors turn away from the space. Like the government-administered interest rates from which this market derives its price, 2021 appears to hold more of the same for both the investment-grade and high-yield bond markets – range bound at low yields.
Return to TINA. In the patois of Wall Street, TINA—the acronym for “There is No Alternative…to Equities”—will continue to hold sway. Compared to fixed income, U.S. equities, even at the current Olympian valuations, will likely continue to attract capital. The promise of a vaccine along with a recovery funded by Congress and fueled by the Fed will draw capital into equity markets on the hope of another year of healthy returns.
It is a good bet that tech and communication services stocks, sectors that gained 44% and 24% in 2020, respectively, will continue to post gains in the early part of 2021 as COVID forces a continuation of work from home. However, a rotation of leadership should occur as herd immunity to the virus is realized and some form of normalcy attempts to emerge. This rotation is seen in the recent outperformance of the S&P 500 equal-weighted index compared to the conventionally referenced S&P 500 index, which is capitalization-weighted (Exhibit E). Winning sectors under lockdown such as tech, media and entertainment, software, food and staples should experience a period of catch up by energy, telecom, real estate, and financial services. Investors are optimistic for profits in 2021. The consensus is for earnings to rise almost 22% on revenue growth of roughly 8%. If these forecasts materialize, earnings per share of the S&P 500 will stand at $169 or roughly 4% higher than 2019.12
Any path to a profit recovery will undoubtedly be marred by periods of market volatility as the inevitable setback unfolds. Intra-year market declines for equities on the order of 7% to 15% should always be expected. In 2021, they should be taken as an article of faith as the logistical difficulties of distributing a vaccine, deep scarring of the labor market, and expected rise in bankruptcies become apparent.
International equities will be the place to watch in 2021. Developed international markets significantly trailed returns in the United States and emerging markets. Collective earnings for the MSCI EAFE Index of international developed market companies is expected to rise to roughly $125 per share in 2021, more than 19% higher than in 2019 (Exhibit F). Given the lack of performance in 2020, a smart earnings recovery could be the catalyst for developed international equities to enjoy a decent year.
Emerging markets will also be worth watching as earnings are expected to achieve levels 21% higher than in 2019. A continually weakening dollar will help emerging markets catch a bid. China will factor prominently in how these stocks will do. If past is prologue, China will test the newly elected Biden administration, taking measure of America’s new leader which can lead to market ructions.
Things to Watch in 2021
A few markets always seem to fail to garner much attention. Can the price of crude oil ever be as glamorous or make for good cable business news banter as the incredible levitation of shares of companies free of profits?
Watch energy prices. Energy companies and the commodity in which they deal are linked. Brent crude trading above $50/barrel appears to signal confidence the economy will escape the clutches of COVID. Brent entered 2020 above $60/bbl., but fell to a low of $32 in April. As recently as the end of October, it was trading in the high $30s. Similarly, the energy sector, which fell roughly 60% in March from the start of the year, has halved that loss. If crude prices continue to rise on expectations of recovering demand, the energy sector may get pulled along with it.
Watch currency prices. Currency movements are nearly impossible to predict, as they are influenced as much by emotion as by quantitative factors. It is the market of the universal and the particular. While this can be said of any asset, currency prices are especially prone to the volatile brew of emotion and economics. Currencies are always quoted relative to something else: other currencies, gold, etc., so a view on the value of one currency is also a view on something else. Last year, the U.S. Dollar fell against all of the Group of Ten (G10) nations’ currencies (Exhibit G). “King Dollar’s” crown is looking tarnished by economic struggles, bloated deficits, and the printing presses running red hot at the central bank. Given the likelihood of a W-shaped recovery, the dollar could well plumb new five-year lows relative to major currencies. Should this occur, international stocks both in the developed and developing world should capture the attention of investors. Similarly, U.S. companies that generate significant revenue from outside the U.S. will likely find a modicum of favor as any revenue created in other currencies will be more valuable relative to revenue generated in dollars. Think industrial, energy, basic materials, and technology.
Watch interest rates, especially the 10-year Treasury yield. Undoubtedly, central bankers will keep interest rates floor bound in 2021. Longer-term interest rates will be key in understanding the mood of investors. Central bank purchases of Treasury securities will muddle the price signal markets usually give. However, markets can still provide a hint of investor attitudes by periodic movements. The rise in the 10-year yield from 50 basis points in August to 96 basis points in early December provides a clue that all the extraordinary policy directed toward the economy may come with a higher price of money…eventually.
Given the events of 2020, it is hard to contemplate the surprises that 2021 might hold. As the accounting for 2020 is finished up, despite all the trials and tribulations, financial markets turned out much better than expected. One can only hope 2021 turns out the same.
1 Barclays U.S. Corporate Investment Grade Index
2 Factset Earnings Insight, December 11, 2020
3 International Monetary Fund World Economic Outlook, October 2020
5 Price only return via Bloomberg
6 U.S. Initial Jobless Claims NSA, Department of Labor via Bloomberg
7 U.S. Employment Total in Labor Force SA, Bureau of Labor Statistics via Bloomberg
8 U.S. Employees on Nonfarm Payrolls Total Private MoM Change SA, Bureau of Labor Statistics via Bloomberg
9 Tallies from John Hopkins University’s Coronavirus Resource Center, December 1, 2020
10 Bloomberg Economic Global GDP Growth (PPP Weighted) Quarter-over-Quarter seasonally-adjusted annualized rate (QoQ SAAR)
11 MSCI All Country World Index Total Return via Bloomberg
12 US GDP Bureau of Economic Analysis QoQ, SAAR, S&P 500 Index total return all via Bloomberg
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.