The tumultuous 2020 calendar year has finally ended. Despite enduring a global recession, most of the world’s stock markets recovered to finish the year with solid gains: the US benchmark S&P 500 Index returned 18.4% while the MSCI All-Country World ex-US Index rose 10.3%. When we issued our last Outlook on October 13, we noted that a heavy fog had obscured financial market forecasting. At that time, major questions regarding the future course of COVID-19, the response of policymakers, and the impact of US politics, were impossible to predict with conviction. We also anticipated this uncertainty to lift by year-end and improve visibility into 2021. This has happened and, on balance, the developments have been positive for financial markets. The consequence has been surging global equities propelled higher by a growing consensus view, which we share: a synchronized global economic expansion will gain steam in the second half of 2021, resulting in another year of rising stock markets.
The greatest factor affecting economic progress remains the battle against the coronavirus. The consensus forecast expects COVID-19 to become more severe in the US and Europe in the first few months of 2021, which has already led to increased restrictions in some countries. However, if vaccine distribution estimates are correct, by the end of the first quarter a hundred million or more people should be inoculated globally and the virus will commence a steady retreat. This positive outcome would lead to the beginning of a “return to normal” by the end of summer. In the US, the current record-high household savings rate indicates pent-up demand and should boost consumer spending in the medium-term. Corporate profits are poised to rebound faster than the economy, surging over 20% in 2021. All eleven S&P 500 sectors are projected to report year-over-year earnings growth. Huge corporate cash positions could spur a new wave of stock buybacks, dividend increases, and mergers and acquisitions activity. In short, the end of the COVID-19 pandemic would likely be accompanied by flourishing economies and stock markets.
The role of the world’s central banks in supporting economies and lifting equity markets should not be underestimated. For example, the Fed has promised to maintain historically low interest rates relative to other recoveries. In 2003, interest rates were between 4.0-5.0%. Following the Great Recession, the yield on 10-year Treasuries vacillated between 3.0-4.0%, whereas currently the yield is about 0.9%. The resulting boost to stocks is twofold: near-zero interest rates support economic growth, but also reduce bond yields to such a low level that the asset class ceases to be a substantial investment alternative for investors seeking capital appreciation. Sovereign wealth funds, pension plans, and retirement plans with balanced investment portfolios are already experiencing pressure to increase equity ratios as their only hope of achieving total return objectives. The power of the Fed is on full display. Generations of investors have learned wisdom in the phrase, “don’t fight the Fed.”
Despite strong tailwinds, our near-term enthusiasm is tempered because the strong equity gains in 2020 occurred in the absence of corporate profit growth, resulting in high valuations. While we think the overwhelmingly positive economic fundamentals will prevail, the road ahead is likely to sustain setbacks and challenges; expensive stock markets pricing in considerable optimism frequently lay the groundwork for corrections. Our view would be any pullback would likely be short and provide a buying opportunity. Our forecast for the year is that 20%+ growth in corporate profits will reduce current sky-high multiples, and US equities will provide a solid 8-10% annual return.
A key strategic question for both US and international investors is where to invest? Should investors favor the growth stocks that performed so well in the second and third quarter of 2020, led by technology and companies benefiting from the “stay at home” economy? Or should investors take the leap of faith that the positive forecast is correct and invest in downtrodden industries such as travel, transportation, banks, and commodity producers? We recommend a broadly diversified blend of the two strategies with a strong emphasis on high-quality, well-established companies which will almost certainly survive, if not thrive, if the bright outlook dims.
We emphasize that our positive case and strategy recommendation applies to both the US and international stock markets. In the fourth quarter, the 12.2% return of the S&P 500 Index was overshadowed by the 18.4% surge of the iShares Emerging Market ETF (EEM). This is not surprising, since emerging markets and highly volatile commodity stocks have been market leaders in the early stages of recovery following each of the last two recessions. Emerging markets are also benefiting from weakness in the US dollar, which is partially a consequence of Federal Reserve policy. Euro Area GDP is expected to grow at 5.2% with a hefty 30%+ increase in corporate profits, both at a faster pace than the US. With European stocks trading at lower valuations than their US counterparts, value-oriented investors may look to the region for opportunities.
The 2020 bear market and its ultimate resolution has reaffirmed our view that keeping a long-term perspective is highly beneficial to improving investment results. We find it especially gratifying to guide our clients through turbulent markets such as last year.
We wish our clients and readers a healthy and happy 2021.
The Marietta Investment Team