We offer the following economic and market commentary for the fourth quarter of 2020.
The longest U.S. expansion came to an abrupt halt in March as the novel coronavirus swept across the country. While the economic recovery has been underway, the effects of the COVID pandemic will continue to reverberate across the U.S. economy into the new year.
Despite the rocky start, the U.S. economy should continue to heal throughout 2021. However, economic activity is likely to remain depressed in the early part of the year. An untenable surge in COVID cases continues to be a major downside risk to the outlook, but the relationship between virus cases and the economy has weakened since the onset of the pandemic.
The wide availability of vaccinations in the second half of 2021 should help life and business return to some semblance of “normal.” Yet the pandemic’s effects on spending, the labor market, and monetary policy are unlikely to fully dissipate. While about two-thirds of the economy’s lost output has been recovered, reclaiming the remaining ground will be slower going forward. Real GDP growth is likely to sputter during the early part of 2021 before taking off when widespread vaccination greatly reduces the need for social distance. Recovery, measured by the level of real GDP, likely will be complete by the third quarter of 2021, but the economy will still be smaller than it would have been in the absence of the pandemic.
In the U.S., highlights of the fourth quarter included promising developments regarding a COVID-19 vaccine, Joe Biden’s win in the U.S. presidential election, and a $2.3 trillion coronavirus relief and government funding package that was signed into law in late December. Further boosting markets, the Federal Reserve reinforced its supportive message, stating it will continue with current levels of quantitative easing. With the Biden victory came the prospect of a less confrontational presidency and more predictable trade policies. The prospect of a safe and effective vaccine, along with a successful rollout, also drove forward-looking equity markets higher.
Overseas, equity markets produced strong gains and outperformed their U.S. counterparts. In Europe, markets were up sharply on vaccine-related news and despite rising infection rates that led to renewed restrictions and lockdowns. Significantly, the European Union agreed to a Brexit trade deal with the UK. In Japan, equities rallied, driven by vaccine-related news and the result of the U.S. presidential election. Emerging market equities produced their strongest quarterly return in more than a decade. Currency strength relative to the U.S. dollar provided a boost while rising commodity prices drove markets representing net oil-exporting countries higher. Chinese stocks rose but lagged the broader emerging market index as escalating tensions with the U.S. proved to be a drag on sentiment.
In fixed income markets, the risk-on environment driven by COVID-19 vaccine news along with fiscal relief efforts boosted non-Treasury sectors. U.S. government bonds finished negative for the quarter as the 10-year Treasury yield rose 25 basis points. U.S. corporate bonds, on the other hand, turned in a strong quarter. High yield bonds led the way as credit spreads fell about 150 basis points during the quarter. Investment-grade international bonds, both developed and emerging, sharply outpaced U.S. issues, aided by currency strength. The U.S. Federal Reserve affirmed its dovish stance at its December meeting, maintaining asset purchases at least at the current level for the foreseeable future.
In the U.S., improving economic conditions are likely to boost business and consumer confidence which, in turn, should drive significant corporate earnings growth in 2021. Increased fiscal spending, accommodative monetary policies, and less contentious trade policies may prove to be profit tailwinds. The victory of President-elect Joe Biden may create a positive backdrop for U.S. markets. Volatility is expected to remain elevated into the new year for at least as long as the duration and impact of COVID-19 remain uncertain. If vaccines prove to be safe, effective, widely distributed and the U.S. economy continues to recover, early cycle outperformers should be in favor. Smaller companies typically lead coming out of a recession, and additional fiscal measures should be supportive of this asset class. High-quality cyclicals, including financials, materials, and segments hit hard by COVID-19 lockdowns such as travel and leisure, are also expected to lead in the early cycle environment.
Equity markets were primarily driven by shifts in valuations in 2020. Going forward, expect corporate earnings to play a larger role. Volatility may remain high, particularly during the first half of the year. If the post-coronavirus economic recovery favors undervalued cyclical value stocks over expensive technology and growth stocks, developed international equities should perform well as major foreign stock indexes are overweight cyclical value stocks, relative to the U.S. In Europe, equity markets are poised for a strong post-vaccine recovery. The European economy suffered a big hit from the pandemic, thus there is an opportunity to rebound from a low base. Europe is also more exposed to global trade than the U.S. and will therefore benefit from a recovery in Chinese demand. In Japan, the rebound from the pandemic is likely to lag other developed economies given structural weaknesses. Government policy, driven by new prime minister Yoshihide Suga, must be closely monitored. In the UK, cyclical forces have the potential to strongly drive GDP following the economy’s sharp contraction in 2020.
In emerging markets, accommodative developed market central banks have been supportive. The expectation is that these policies will continue. Developing nations should also benefit from an uptick in cyclical global growth in 2021, more predictable U.S. trade policies under a Biden administration, and a weaker dollar. Finally, China and some other Asian countries appear to have had greater success in containing the virus, and, therefore, are further ahead in their recovery than much of the developed world. Along with the tailwinds, emerging markets also face significant challenges exacerbated by the coronavirus pandemic. The EM asset class is a complex one that includes many markets with disparate characteristics. Emerging countries with stronger fundamentals may disproportionately benefit. In short, while exposure to emerging market stocks is certainly appropriate, significant risks remain and caution is prudent.
The fixed income market is characterized by record supply, historically unique monetary policies, and government deficit spending. These trends are likely to continue through at least the first half of 2021. Volatility is expected to remain elevated, and interest rates are generally projected to remain at low levels for the foreseeable future. Investors may benefit from active management in the current environment, particularly when allocating to lower-quality investments. Assuming stimulus for states is forthcoming, municipal bonds will benefit. Dollar depreciation is a potential tailwind for international bonds. Broadly speaking, fixed income should continue to play a useful role in managing overall portfolio risk.
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Based on the S&P 500 trailing twelve-month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a current reading at the 3rd percentile from January 1957 to January 11, 2021.
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity registers a November 2020 reading at the 98th percentile from January 1979 to November 2020.
The equity valuation and economic activity gauges have been reviewed by GW & Wade and are consistent with the firm’s near-term outlook.
This economic and market commentary was prepared by Capital Market Consultants, Inc. (CMC), an independent investment management consulting firm, and has been approved for distribution by GW & Wade, LLC. Data used to prepare this report by CMC are derived from a variety of sources believed to be reliable including well established information and data software providers and governmental sources. CMC is not affiliated with any of these sources.
The information provided above is general in nature and is not intended to represent specific investment or professional advice. No client or prospective client should assume that the above information serves as the receipt of, or a substitute for, personalized individual advice from GW & Wade, LLC, which can only be provided through a formal advisory relationship.
About the indices presented above:
Standard & Poor's 500 (S&P 500®) Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance. The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the Nasdaq.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
The MSCI ACWI (All Country World Index) is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world.
The MSCI EAFE Index is an equity index which captures large and mid cap representation across Developed Markets countries around the world, excluding the US and Canada.
The MSCI Emerging Markets Index (EM) captures large and mid cap representation across 24 Emerging Markets (EM) countries.
The Bloomberg Barclays Global Aggregate Bond Index measures global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
The Bloomberg Barclays US Aggregate Bond Index measures the performance of the U.S. investment grade bond market. The index invests in a wide spectrum of public, investment-grade, taxable, fixed income securities in the United States – including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities, all with maturities of more than 1 year.
The Bloomberg Barclays US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. GW & Wade assumes no duty to update any of the information presented above.
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