Economic Commentary – Q4 2020

 

Financial markets performed admirably in the fourth quarter even as the pandemic raged across much of the world, partly attributable to two critical developments: the conclusion of the US election and the arrival of multiple vaccines. Now that the much-discussed political uncertainty has been removed and an end is in sight to the pandemic (assuming the vaccines work and are broadly accepted), investors embraced a “risk on” attitude based on a return to normal.

Another key event was passage of an additional economic assistance package by Congress which ironically was enabled by the increasing severity of the pandemic and associated economic malaise from regional shutdowns. From our vantage point, it seems apparent that stimulus, from both monetary policy and fiscal policy, was a major catalyst for the fantastic performance of financial markets since the dark days of March. We could list the figures and programs in detail, but the point is that financial conditions have been eased dramatically thanks to substantial, swift, coordinated response both here and abroad, and more may be on the way as the pandemic continues to rage and the economic costs manifest themselves.

Bond returns were decent during the quarter as Treasury bond yields on the front end of the curve (0-2yr) were the same or lower while yields further out (5yr+) were up by 8 to 23 basis points, due in part to the stimulus package noted above. Corporate, municipal, and mortgage-backed bonds performed better than Treasuries since, with Treasury yields so low, many investors clamored for the higher yields they offer.

Equities were decidedly more thrilling during the quarter as shown in the table. As is often the case, crisis begets opportunity and the pandemic appears to have accelerated burgeoning trends that were in their nascent stage. We are all familiar with most of them: working from home (or WFH, a new shorthand that already feels like one we’ve used for years), learning from home, cooking at home (sourdough anyone?), home work-outs (who knew cycling would be so “in”), and video meetings. Many were lured into investing in companies benefiting from these trends as evidenced by the huge number of brokerage accounts opened this year, and stories about cryptocurrencies and electric cars continue to grab our attention even today. We are not interested in several of these investment fads but one trend we are enthusiastic about concerns the advances in health care research as scientists work to develop new products for treatment and prevention of disease. While the current focus targets COVID-19, these recent innovations could allow for other medical breakthroughs in the coming years, which is very exciting indeed.

In terms of our economic outlook for 2021, we expect a materially higher growth rate for the broad economy assuming the vaccination effort continues unabated. The hardest-hit industries in 2020, most of which are in the service sector, will likely enjoy robust gains as consumers return to more normal patterns of behavior. We expect a gradual, though back-end loaded, return to “normal” will also allow the labor market to improve, although we do not expect the unemployment rate to reach the low of 3.5% set in 2019. We expect the residential construction market to register solid growth as well. Housing is an important industry with powerful trickle-down effects and is benefitting from rising demand, low mortgage rates, and tight supply.

Faster growth will no doubt give rise to some inflation worries. Our view is that inflation measures will creep a bit higher in 2021 due to some transitory factors, but we do not expect runaway inflation to develop. The Fed would welcome higher inflation since they and all the other developed market central banks have been unsuccessful in this realm for some time, and deflationary trends remain solidly in place across most of the world. That is one of the main reasons for their policy change in the first place. We would advise not to worry if the inflation bears start to get louder on TV and to change the channel to issues that do deserve some thought.

One example deserving some thought: financial conditions have become very loose, meaning the cost to borrow is extremely low and the ability to raise capital is easy. One of the dangers from such conditions is the building up of excess leverage in the system and the misallocation of capital. If and when another economic downturn occurs, financial conditions can tighten quickly, and excess leverage can cause companies (or government entities) to find it difficult to meet their fixed obligations or roll over their debt on favorable terms. Many examples can be cited throughout history, but industries exposed to sudden technological change, commodity price changes, or foreign competition have often been the most impacted. In addition, with money so cheap to borrow and growth still rather slow, we expect merger and acquisition volume to remain elevated in the coming year, but this too can be a source of misallocation of capital which can sometimes prove calamitous at the company level.

Also of concern is the vast amount of debt that’s been issued by government and business alike, mostly to deal with the pandemic but also due to the 2017 federal tax cut as well as a very active pace of debt-financed mergers and acquisitions. Since the cash flow generation of many borrowers has been reduced, it is more important than ever for borrowers to get serious about reducing debt and improving their balance sheets. At the risk of repeating ourselves, we still believe this set of facts calls for caution and selectivity when investing in bonds.

These are our chief concerns at this time, yet we remain guardedly optimistic as the vaccine rollout gathers momentum and the political season calms down. We expect this year may prove a bit more choppy than the last six months and we are alert to finding opportunities to add value to your portfolio.

We wish you all a safe, healthy, and prosperous year in 2021 and we remain humbled and grateful to play a role in your financial strategies.