Winter 2021 Market Perspectives

<b>David S. Lynch, CFA</b><br>Chief Investment Officer

David S. Lynch, CFA
Chief Investment Officer

January 19, 2021

Market Perspectives

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The fourth quarter featured two pivotal events: the Presidential election and the first COVID vaccine approvals. These headlines resulted in a rally for the markets and started some rotation by investors. Value stocks outperformed growth stocks after a sustained period of outperformance by growth and technology stocks.  International equities, both developed and emerging markets, outperformed the S&P 500 during Q4. Sectors such as energy bounced back on the hope for a resumption of global economic activity once vaccines are more widely distributed. Financials also rallied as the yield curve began to steepen. 
Q4 provided a glimpse of some of the equity sector rotations that could feature prominently once the pandemic era ends. Q4 also brought a tentative rise in bond yields on the expectation of a recovery in economic activity alongside the Fed’s greater tolerance of inflation. Many of these trends carried over into early January.
We will participate in some of these tactical rotations as an opportunity to enhance portfolio performance. However, our primary mandate remains focused on finding longer term investments that can be patiently held for multiple years. Some of these budding rotations and reversions to the mean have been building for so long that they could rise to fit the multi-year secular and strategic opportunities that we prefer. Similarly, some of the relatively high-priced stocks of the current moment still fit as attractive multi-year compounders such that some portion of these holdings will remain as core positions even in the face of the volatility that is likely to follow them in the short term.

Market Outlook and Q4 Summary


Overall Asset Allocation

Depending on the strategy and stock/bond mix chosen, most portfolios produced double-digit positive performance for 2020—a healthy return considering the state of the world. Our expectations are for more modest returns in 2021, perhaps in the low-to-mid single digits depending on asset mix. We hope to be surprised to the upside, but want to remain humble about how far the markets have come and how reliant current valuations are on relatively “artificial” means such as stimulus and unorthodox policy.

We enter 2021 with a general recommendation to be neutral equities, underweight bonds, and overweight cash. Bonds still work for portfolio diversification but are less helpful given these low starting yields. Therefore, we prefer some cash to complement bonds at this point in the cycle as the counterbalance to the equity exposure currently in portfolios.
Global investors flush with stimulus cash, facing low interest rates and lack of other alternatives, have given the stock market the benefit of the doubt that earnings will ramp back up quickly in 2021. These earnings will have to come through to justify the high price-to-earnings multiple on the current market. Performance for 2020 varied widely across industries and sectors. On the low end of the spectrum, energy was down 34% for the year, and technology was up 44% on the upper end. This dispersion should set up for continued opportunities for active investors. 
There are likely some excesses in the market as evidenced by the IPO boom, the growth of “blank check” SPACs (Special Purpose Acquisition Companies) and the persistence of “zombie” companies with a debt service burden greater than profits.  However, this is not the dot-com era all over again. The excesses, while real, are more off to the side this time. Market capitalization leadership is much more viable, profitable, and better positioned than it was in the dot-com bubble. Market leaders such as Facebook, Amazon, Apple, Microsoft, and Alphabet (Google) are not without material risk and vulnerabilities though. Many of them could easily be targets of anti-trust or regulatory backlash. They could also be victims of their own success in terms of having a harder time growing into their already lofty valuations and expectations. Position sizes should be closely monitored, and trimmed if necessary, as increased volatility in these names is expected going forward.

Global Equities

The S&P 500 was up 12% in Q4 to finish the year up 18%. In Q4, some of the out-of-favor sectors started to rebound. Energy and financials were up 28% and 23%, respectively. Industrials (+16%) and materials (+14%) also had a strong quarter.  Small cap stocks, as measured by the Russell 2000, were up 31% in Q4 to get back into positive territory at up 20% for the year. The Dow Jones Dividend Select Index was up 19% in Q4 but remained negative for the year at -5%.
Q4 was a rare quarter where the US lagged international markets with the MSCI All Country World ex-US Index up 17%, which brought that index to up 8% for the year. Emerging markets also had a great quarter, up 20%, to get back into positive territory for 2020 at up 19%. International equities also saw a wide dispersion in underlying performance in 2020. For example, China was up 30% for the year while Brazil was down 19%. Similarly, Japan was up 12% while Europe was only up 3%. These wide regional differences provide further support for careful selection and active management within international equities.

Fixed Income

Bonds were up modestly across most markets with intermediate- and long-dated US Treasuries as the only negative primary sectors in Q4, down 1.3% and 3.2% respectively. High yield and emerging market debt were the best performing bond segments in Q4, both up 6%. For the full year, most bond sectors produced mid-to-high single digits returns after a strong recovery from the dislocations of March.
The Federal Reserve continues to promise patience and dovishness alongside an incoming administration that will likely look to boost spending on stimulus, infrastructure and related priorities. This combination of concurrent monetary and fiscal stimulus amidst a vaccine rollout that should revive organic economy activity has put bonds under some pressure in recent weeks. 
Prolonged economic stagnation and deflationary pressures are still possible.  However, we enter 2021 believing inflation is more likely than it has been in quite some time. The critical question is whether it will be a gradual rise in inflation that can be steered and managed by policymakers, or if it gets out of control in a way that forces more sudden and serious cracking down by the Fed than currently planned. We moved to underweight fixed income in November and will be waiting for better re-entry opportunities.

Other Asset Classes

Gold prices were essentially unchanged for Q4 and finished the year up 21%. The Bloomberg broad commodities index was up 10% for the quarter on the hopes of resumed economic activity, but the pandemic-induced recession earlier in the year kept full year performance negative at -3%. Oil saw a rebound of 18% in the quarter but was still down 51% for the year. Copper was up 16% for the quarter and 23% for the year. The Bloomberg agricultural commodity index was up 21% for Q4 and up 16% for the year. We are actively researching opportunities to add hard assets to portfolios for further diversification and offset to rising inflation risks.



During Q4, our asset allocation committee moved to underweight fixed income and maintained a small overweight to cash. This tactical adjustment is not a strong indictment of fixed income but rather an acknowledgement that the risk/reward trade off, particularly of low yielding and short duration bonds, is not sufficiently differentiated from the more predictable safer haven of holding some outright cash. We are neutral on equities with the expectation that we will likely be adding to international equities during 2021.
Global diversification makes sense from multiple angles for 2021. It makes basic sense, as it always does, in spreading out risk to better absorb any potential localized dislocations. This year it makes further sense with US markets having massively outperformed in recent years, with the US political and social landscape remaining unstable, and with other regions of the world well positioned for recovery and growth, such as Asia and certain emerging markets.
As a final note, while tragic for our society, the dramatic events at the US Capitol in early January have not been overly upsetting to the markets thus far. As we publish this article, we are hopeful for a smooth Inauguration Day. Generally, the markets have carried on unaffected, but there is a looming connection point that bears watching. To the extent that social unrest is in some ways the result of widening income inequality, there could ultimately be economic and investment implications if/when the administration attempts to address those inequalities. We will continue to monitor these risks and adjust portfolios as needed.