If 2020 was uniquely challenging, 2021 is providing its own set of extraordinary dynamics. The start of the year has seen a continued surge in COVID-19 cases and deaths, a shift in the Senate’s balance of power and the shocking breach by protesters at the U.S. Capitol, followed by the second impeachment of the former president.
In contrast, economic prospects appear reasonably positive. Although the first quarter may see continued weakness tied to the pandemic, the country is likely to experience a gradual return to economic normalcy over the rest of the year, characterized by an acceleration of growth fed by loose monetary conditions, fiscal stimulus and, importantly, the release of pent-up demand as society and business get back on their feet. The course of vaccine distribution remains crucial to this viewpoint, and despite some delays we are reasonably confident about a ramp-up of inoculations over the course of the year.
The investment picture is a bit more nuanced.
One remarkable aspect of 2020 was the resilience of equity markets, which surged from March lows with the help of rapid action by central banks and fiscal authorities and have since hit new highs. Bond markets also reacted positively to monetary policy that lowered short-term interest rates to around zero and supported liquidity through bond-buying and other measures. Many non-Treasuries have seen their valuations move back to pre-crisis levels.
A key question has become, what could drive the market further? We believe that the force of the recovery could be significant and will likely go on for a number of years. At this point, we expect U.S. GDP to surge 5% in 2021, compared to the decline of about 3.5% in 2020, while market consensus calls for S&P 500 earnings to grow 22% from depressed 2020 levels. Assuming things generally go well, this would logically suggest that equities could continue to appreciate over the next 12 months, albeit not to the degree experienced over the last two years, while credit conditions could support modest price improvement for non-Treasury fixed income assets.
Elevated Savings Could Help Jumpstart Recovery
Source: Bloomberg, as of October 2020. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed.
Corporate Earnings Are Likely to Rebound This Year
S&P 500 Annual Earnings per Share
Source: FactSet, as of January 8, 2021. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
Still, a number of issues could affect how 2021 proceeds.
COVID-19. The virus accelerated with colder weather and holiday travel, even as drug companies and governments work feverishly to create, distribute and inoculate populations. In the U.S., a key hindrance is the decentralized approach that relies on the states, many of which are not well prepared or funded for the large-scale logistics. President Biden has pledged more coordination and state aid, as well as an acceleration in vaccinations, but the challenges are significant. An extension of lockdowns and delays in reopening could hamper the economy and potentially have a bearish impact on markets.
Inflation. Although it may be surprising to some, inflation may soon become a concern again. The pandemic created significant slack in the economy, given the decimation of many businesses and the large number of unemployed. However, manufacturing indicators are already at or above pre-COVID levels, while service businesses could see a rapid revival with reopening. Meanwhile, the Federal Reserve is unlikely to do much to restrain near-term exuberance, given continued virus uncertainty and the severity of recent economic shocks. Indeed, it has revised its processes to allow for more “heating up” of the economy before applying the brakes. Depending on conditions later in the year, however, it could start to take tentative steps, including tapering some bond-buying.
Global Manufacturing Has Largely Rebounded From the Crisis
Manufacturing PMIs (50+ Represents Expansion)
Source: Bloomberg, as of November 2020.
Populism. To many, 2021 was supposed to be a year when things went back to normal. But the events of January 6 have further exposed the bitter divisions in our country, even if the new president employs a more positive, less confrontational approach to governance.
As noted in our Solving for 2021 outlook, we believe the populism that helped propel Donald Trump to the White House remains a potent force, and could influence policy for years to come. Most significantly, we believe it could provide continued momentum to government spending, especially with the recent shift in political control—leading to larger deficits and creating pressure for higher taxes.
The Blue Wave. Joe Biden’s agenda appears to be very different from that of the Trump years, emphasizing not only significant COVID relief and infrastructure spending, but health care, climate and tax increases. In terms of executive action, we will likely see the country rejoin the Paris Agreement on climate, the reinstitution of the DACA program, and in general a higher level of regulatory oversight, including to the energy and financial sectors. Georgia runoff victories ensured Democratic control of the Senate in addition to the House and presidency, but a narrow majority will likely put moderates in the driver’s seat on many issues, especially with removal of the Senate filibuster likely off the table. Cabinet picks could be approved more readily, while, assuming a budget is passed, reconciliation rules may allow for approval of spending and tax measures by only a simple majority.
Certain popular issues, including COVID relief and infrastructure programs, are likely to get immediate attention, but more ambitious and controversial proposals (e.g., climate spending and health care reform) may be scaled down and subject to horse trading.
Democrats’ Control of Congress Is Historically Narrow
Percentage of House and Senate Seats Held by Democrats After Each Presidential and Mid-term Election
Source: J.P. Morgan.
Global tensions. In general, the tone of U.S. foreign and trade policy is likely to be more friendly and less confrontational moving forward. However, with significant changes on the global scene over the past four years, we are unlikely to see a simple reset to Obama policies. For example, sentiment has hardened on China policy, in terms of trade practices and regional presence. Recent foreign incursions into government data systems have increased tensions and concerns about digital security. In the Middle East, strategic realignments may make a return to the Iran nuclear deal more challenging.
Still, despite some worries around the Democratic agenda, stock investors have generally taken the new mix of government as positive, particularly given the increased likelihood of stimulus and broader spending, which could support recovery. Meanwhile, bond markets have been more circumspect, with Treasury yields rising and the dollar easing on the potential for this spending to stimulate inflation over time.
As noted in our Solving for 2021 outlook, we believe a range of investment themes could impact market behavior and investment decisions in 2021.
Shift toward value. In equities, a key idea is to lean into value and cyclical shares in the near term, given the extended valuations of large U.S. growth stocks and the historical outperformance of cyclicals during the early stages of economic recovery. As part of this tactical emphasis, exposure to more value-oriented non-U.S. markets may be appropriate.
Transformative trends. That said, the thematic disruptions we have frequently articulated have greatly accelerated during the pandemic, as digital transactions, telehealth, next-generation connectivity and automation, among others, have taken hold. As the recovery matures and the economy eases to a more measured pace, we believe companies that can maintain earnings growth could see a return to performance leadership.
The Pandemic Has Accelerated Digital Trends
What Percentage of Your Workforce Will Remain Permanently Remote Post-COVID Who Were Not Before COVID?
Source: Gartner, Goldman Sachs. March 30, 2020 survey of 317 corporate CFOs.
Tax-efficiency. Of particular importance to individuals, the growth of spending tied to the pandemic and populist sentiment generally may create pressure to raise taxes, with near-term change more likely now that the Democrats control the executive and legislative branches. This may increase the potential of tax-efficient portfolio management, including long-term holding periods and tax-loss harvesting to benefit from anticipated price volatility.
Search for income. For bond investors, the search for income continues in an environment where many global bonds provide minimal to negative yields and there’s a chance of renewed inflation. Tax-free municipals may have appeal to limit the impact of potentially higher tax rates, while corporate high yield bonds may be worth considering in light of their relatively moderate exposure to inflation risk and generally improving credit conditions.
As always, we believe maintaining broad diversification is essential, across equities, fixed income and, where appropriate, private equity, which could provide distinct return characteristics and a potential premium in exchange for reduced liquidity.
Setting Your Rate of Speed
The market has recently combined a unique combination of grim conditions—raging pandemic, political conflict, stressed economies—and hope for the future tied to vaccines, reopening and a return to normal. With the seeming removal of some obstacles, markets have generally raced forward. However, the potential for setbacks and new challenges remains real. Maintaining a moderate rate of speed, based on insight and in close consultation with advisors, can help maintain a proper course as we work through the last leg of a difficult period.