2020 Year in Review As I ponder how to describe 2020, I struggle to find appropriate words. Let me begin by borrowing a sentence I used at the end of my 2020 Outlook – “Of course, despite all of our best laid plans, events through 2020 will likely conspire to force us to alter our thinking in one direction or another”. That about sums it up, don’t you think?
Naturally, we could not anticipate a global pandemic but it has truly been the only story of relevance to financial markets in 2020 - not to mention its toll on so many families. The spread of the virus, its health consequences, lockdowns, employment losses (with subsequent partial rebound), global monetary and fiscal stimulus measures, and progress on vaccines all took their turn in driving financial market swings. Yes, other events influenced (politics…) but they paled in comparison to Covid-19.
Remarkably, looking at 2020 financial market returns, you would never have guessed the world has been dealing with its worst health crisis in a century. U.S. equities gained 18.4% (S&P 500), international developed equities rose 7.8% (MSCI EAFE), emerging market equities advanced 18.3% (MSCI emerging market) and U.S. fixed income rose 4%-7% depending on the index.
This year’s market strength has puzzled many observers. How could financial markets have performed so well when so many people have lost their jobs, not to mention their lives? While the answer is rather straightforward, let me remind you that it has not been a smooth ride. As fear over Covid’s mortality and spread climbed and as economic lockdowns forced 22 million people into unemployment in the U.S. and millions more globally, the S&P 500 fell by 32% from February 19th to March 23rd – an interval of just 33 days. The decline over such a short period was the sharpest on record.
However, March 23rd proved to be the market bottom. Since that time, equities have generally trended higher. How is this possible given that the virus contagion is actually worse right now than during the depths of March? The simple answer is that, as is typical, markets bottomed just slightly before the economy bottomed. The Federal Reserve stepped in with strong monetary support while Congress came through with timely stimulus checks, unemployment benefit increases and payroll support for businesses. Job growth resumed in May, year-over-year earnings growth bottomed during the second quarter and economic growth turned positive during the 3rd quarter. Equity markets rallied further during the final months of 2020 as stocks priced in a strong 2021-2022 economic environment spurred by vaccine success.
To be clear, not all companies suffered through the pandemic. The pandemic accelerated digitization trends already in motion, producing record years for many companies. From an investment standpoint, we did our best to tiptoe around the minefields and take advantage of the changing landscape.
2021 Market Outlook
U.S. Equities As we turn our attention to 2021, we foresee very strong economic and corporate earnings growth. In fact, we expect that economic strength will remain elevated well into 2022 given our current depressed level and a return to a more normal environment. We anticipate the rebound to be further supported by large pent-up demand for experiences as people slowly emerge from their cocoons. From a timing perspective, we forecast economic growth to accelerate through 2021 as headway is made on global vaccinations and as employment rises.
On the U.S. corporate earnings front, after an expected 16% drop in S&P 500 earnings during 2020, estimates call for a 20%-25% rebound in 2021 to reach record earnings levels. Furthermore, we expect earnings growth to remain above average in 2022 but to naturally moderate from 2021’s elevated levels.
Normally, the strength outlined above in economic, earnings and employment growth would be conducive to a very strong stock market outlook. However, as we pointed out earlier, some (but not all) of this good news has already been reflected by 2020’s outsized gains. This has resulted in U.S. stock market valuations rising to quite elevated levels. The S&P 500’s price/earnings ratio (P/E) is roughly 27.5X 2020 earnings - but 2020 earnings are depressed. Based on 2021 expected earnings, the S&P 500 P/E ratio is a more palatable (for the environment) 22.4X. Ultimately, we expect valuations will move to normalize below 20X over a period of years but not all at once.
In deriving a U.S. stock market forecast, we are encouraged by our expectations for a strong economic, employment and earnings backdrop but acknowledge high valuations. As such, we forecast U.S. equities to rise by 10%-15% in 2021 which would lag estimated earnings growth of 20%-25% and allow valuations to begin the process of reverting to the mean.
International Equities For the same reasons we are optimistic about returns in U.S. equities, we likewise forecast international equities to rise by 10-15% in 2021. With valuation levels lower than the U.S. and with a generally more cyclical leaning, an argument can be made that international equities should outperform the U.S. in 2021. We would prefer to take a wait-and-see approach given the persistent underperformance of international equities vs. U.S. equities (7 of the last 8 years).
U.S. Fixed Income In determining our outlook for U.S. fixed income, we must break up our analysis between short and long-term bonds as they are influenced by different factors.
Shorter-term bonds (less than 2-year maturities) are impacted most by Federal Reserve policy decisions. Given that the Federal Reserve has been adamant about letting the recovery gather steam and in letting inflation run higher than normal before raising interest rates, we expect no change in Fed policy through 2021 and well into 2022 (or longer). As a result, short-term bonds will most likely produce 0%-1% returns in 2021.
Longer-term bonds are more impacted by inflation expectations which are influenced by economic growth expectations. Given our optimistic outlook regarding the growth environment as well as the current low 0.92% yield on a 10-Year U.S. Treasury Bond, we expect longer-term bond yields to rise towards 1.5% as the year progresses. As such, we estimate longer-term bonds may produce 0%-2% returns in 2021.
Given our modest fixed income return expectations, one might wonder if it makes sense to hold any bonds at all in a portfolio. Of course, the answer depends on your specific investment objectives and risk tolerance but, generally speaking, the answer is yes. Bonds play a role as a buffer to volatility in the stock market. If 2020 proved anything, it was that life does not always go as planned. Owning some amount of bonds can often cushion the portfolio during stock market corrections.
In summary, the emergence of the U.S. and global economies from their pandemic-induced recession should spur strong economic growth over the next few years. While some of the good news has already been reflected in equity markets, we believe that there is further room for upside should events play out as expected.
So now let me end my 2021 outlook with the final paragraph from our 2020 outlook highlighting that, no matter the rigor of our analysis, we must never demonstrate hubris.
Of course, despite our best laid plans, events through 2021 will likely conspire to force us to alter our thinking in one direction or another. We will continue to be vigilant and adjust our thinking and strategy as events warrant.
Wishing you a Happy, Healthy, Safe and Successful 2021!