Quarterly Newsletter 4th Quarter 2020
Melt Up
by Daniel Eye
Market Update
U.S. and global equities advanced by double-digits in the fourth-quarter, posting their third-straight quarter of gains since the deep declines in February and March. Positive vaccine developments played an outsized role in setting the tone of the markets. Market optimism was also underpinned by a better-than-expected Q3 earnings season, continued signs of economic resilience and confidence in the central bank backstop. Political outcomes were also viewed as a net positive, as investors embraced expectations for limited policy changes.
There were no dramatic changes in the bond market this quarter. Yields grinded a bit higher on the longer end of the maturity spectrum, where bond pricing is less influenced by Federal Reserve policy. While fourth-quarter returns were muted, the significant contraction in interest rates in the first half of 2020 resulted in strong full-year fixed income returns. Looking forward, a repeat performance in 2021 would require intermediate-maturity government bond yields to compress from all-time lows to zero or below. Possible, but not an outcome we want to bet on.
Below is a summary of fourth-quarter and full-year 2020 performance results for several major indices:
| Asset Class | Index | Q4 Return | 2020 Return |
| U.S. Stocks | S&P 500 Index | 12.2% | 18.4% |
| International Stocks | MSCI EAFE Index | 16.1% | 7.8% |
| Global Stocks | MSCI ACWI Index | 15.7% | 16.3% |
| Municipal Bonds | Barclays Municipal 1-5 Yr. Bond Index | 0.3% | 2.8% |
| Taxable Bonds | Barclays U.S. Aggregate Bond Index | 0.7% | 7.5% |
Economic Update
The economic rebound lost some momentum in the fourth-quarter as policymakers renewed lockdowns and travel restrictions. While these restrictions were not as draconian as those enacted in the spring, they created economic headwinds. Fourth-quarter employment reports, initial jobless claims and retail sales data were evidence of a leveling off in the economic recovery.
While the lockdown’s economic impact will likely carry into 2021, passage of the elusive fifth COVID-19 relief package should provide an offset to this drag. The $900 billion package includes another round of scaled-down stimulus checks, additional unemployment benefits through mid-March and $325 billion in business relief.
Closing Thoughts
Like most, we are eager to turn the page on 2020 and look forward to brighter days. The successful development of COVID-19 vaccines and the ongoing distribution efforts should be the turning point for the public health crisis, and provide a meaningful boost to impaired economic segments. We expect strong but uneven economic growth in 2021, with more robust growth in the second half of the year. The unemployment rate should continue to decline as employees are called back and new jobs are created. Pent-up demand in the consumer and business sectors should serve as the catalyst for a rebound in corporate earnings in 2021. We also anticipate a significant increase in shareholder returns in the form of dividend hikes and share buybacks, as corporations disperse the massive liquidity they amassed in the spring of 2020.
Despite these positive tailwinds, risks have certainly not disappeared. The S&P 500 Index has advanced by more than 50% over the previous two years, leaving valuations elevated and investor sentiment very bullish. This leaves markets vulnerable to bouts of volatility and corrections if outcomes do not match optimistic expectations. Undoubtedly, the ultra-low interest rate environment has been a major contributor to the massive equity market rebound. But interest rates could rise in 2021, driven by an improving economy and a sharp increase of bond market issuance to fund government spending and deficits. At some point, rising bond yields could translate into a headwind for equity markets by pressuring valuation multiples.
We also wonder if 2021 will be the year when inflation reemerges as a concern. The monetary and fiscal response to the COVID-19 crisis has exceeded 15% of GDP – an astounding number. And more is on the way. While these unprecedented liquidity injections have yet to spark inflationary pressures, this could change as economic activity picks up and excess capacity is absorbed. Several capital market indicators are suggesting a higher probability of inflationary pressures than in years past. This is something we will be watching closely as 2021 progresses.
Putting it all together, 2021 could be a year where the economy outperforms the equity markets. Massive amounts of liquidity combined with above-average economic and corporate earnings growth should be enough for another year of positive equity returns. However, the upside looks more limited than the previous two years due to the starting point of stretched valuations. On the fixed income side, we think investors will be lucky to earn their coupon/yields on bonds this year. The math just does not support much more price appreciation from bonds.
The Light at the End
Looking back at my forecast from last year, I mentioned that China was a wildcard for 2020. Little did I know! My focus was on trade and the inability of the Chinese to play by the rules. The thought of a virus engulfing all aspects of our lives was certainly not part of my forecast. However, China not playing by the rules certainly took center stage in 2020.
Any discussion about the economic impact of COVID-19 pales in comparison to the human suffering currently occurring throughout the world. As discouraging as it is, however, we cannot talk about one without discussing the other. The pandemic’s human and economic effects are directly linked and will continue to be until this chapter is finally closed. Policy leaders have continued to walk the fine line between saving lives and bringing the economy to a standstill – and thereby ruining peoples’ financial lives. Clearly, no one was prepared for this, and we continue to adjust to the information we get daily. We’ve seen how fragile even a thriving economy can become during a pandemic.
2020 started with the best employment numbers the U.S. has ever seen. Most people who wanted a job were able to find one. The unemployment rate was below 4% and GDP growth was higher than what we had experienced in years. There were rumblings on Wall Street that the Fed might have to move at some point during the year to raise rates to deter inflation. The 10-year Treasury rate was over 2% and there were thoughts that it could go higher. Then, late in the first quarter of 2020, the unimaginable happened. COVID-19 quickly traveled from China to Europe and the U.S.
From an economic standpoint, I can’t stress enough the great job the U.S. Federal Reserve did with monetary policy. Fed Chair Jay Powell not only reduced overnight interest rates to zero, but he also revived and enhanced some of the rescue programs implemented during the financial crisis. Beyond lowering the overnight interest rate from 1.5%-1.75% to 0-.25% in March of 2020, the Fed also added over $700 billion to the financial system as a backstop – to prevent the biological crisis from morphing into a full-blown financial crisis. They also were able to remove fear from the system and somewhat prevent a flight to quality by shoring up money market funds. These actions gave investors the confidence they could redeem their cash when they needed it. After a few squirrelly days, the fixed income market stabilized.
Going forward, after experiencing the worst recession since WWII, we should expect some light at the end of the tunnel in the second half of 2021. With a better understanding of mitigation factors and a vaccine already being administered, the U.S. should be able to attain some level of normalcy. Still, I would caution that it will take a while for much of the service industry to get back on their feet, if ever. Many restaurants and small businesses have closed, and it is extremely unlikely they will ever return. It may take a while for these individuals to enter back into the working economy. However, I am confident that our resilient economy will look much different when writing this a year from now. Americans are optimistic by nature. To quote Colin Powell: “Perpetual optimism is a force multiplier.” Let’s all look forward to a better 2021!
Quarterly Review
by Denny Baish
Global equity markets posted significant gains in the last quarter of the year. Large market capitalization U.S. companies, represented by the S&P 500 Index, gained +12%. Domestic small-cap companies, represented by the Russell 2000 Index, surged +31%, while mid-caps advanced a little less than +20%. International equities posted positive results in the quarter as well. The MSCI Emerging Market Index, a proxy for developing countries, gained +20%. The MSCI EAFE Index, a proxy for international developed stocks, finished the quarter with a +16% return.
Promising results from coronavirus vaccine trials and another fiscal stimulus package helped push the U.S. stock market to record highs in the fourth quarter. Several drug companies began to distribute the vaccine in the United States toward the end of the year with the first doses going to front-line healthcare works and the elderly. Toward the end of the quarter, Congress agreed on a new round of stimulus checks of $600 for individuals making less than $75,000, couples making less than $150,000, and $600 for each dependent child under the age of 17. In other news during the quarter, results from the U.S. Presidential election showed former Vice President Joe Biden winning the election by popular vote and securing the majority of votes in key battleground states making him the next President of the United States. Another, much bigger, economic stimulus package now seems likely once President-elect Biden takes office in January. Also, during the quarter, the Federal Reserve continued with its accommodative policy of low interest rates and bond purchases.
Much like the broad equity indices, the underlying domestic equity categories had a strong performance in the fourth quarter. Domestic small-cap companies, represented by the Russell 2000 Index, led the way and gained +31%, while mid-caps also added +20%. Large-capitalization companies, represented by the Russell 1000 Index, finished the quarter with a gain of +14%. For the first quarter in more than one year, value indices outpaced growth indices across all market capitalizations. Large value gained +16% and surpassed its growth counterpart by +5%. Small value returned +31% and outpaced small growth by more than +3%. Mid value and mid growth gained +20% and +19%, respectively.
The fixed income segments posted positive results in the quarter. The U.S. high yield bond market, represented by the Bloomberg Barclays U.S. Corporate High Yield Bond Index, was the biggest gainer among fixed income segments and finished the fourth quarter with a +6% return. The Bloomberg Barclays U.S. Aggregate Bond Index, a proxy for the overall investment grade U.S. fixed income market, finished the quarter with a gain of a little less than +1%.
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