Economic Market Update: 2020 Review
2020: A year unlike any other in modern history.
The adjective unprecedented was used liberally throughout 2020 to describe events over the course of the year – and the year itself. A more apt term to describe 2020 comes from Latin in the phrase sui generis, meaning “of its own kind” or “in a class by itself.” The phrase originates from biology, used to describe a species that does not fit into a genus that includes any other species. To describe 2020 as sui generis certainly falls within the spirit of that original usage.
The COVID-19 outbreak presented the world with a global health challenge on a scale not seen since the Spanish Flu outbreak of 1918. Economies around the world experienced the sharpest, deepest recession on record. After beginning the year at all-time highs, stocks experienced a severe bear market, led by the largest waterfall decline in the stock market since the crash of 1929 in March 2020 as the nature of the pandemic started to come fully into view. Despite all this, markets ended the year strongly in positive territory, with the Dow and S&P 500 once again at all-time highs. Markets started and ended 2020 at all-time highs, but investors took an extremely wild ride to get there.
To say 2020 was “yet another eventful year for the global economy and geopolitics” is an understatement.
- The rampant COVID-19 pandemic resulted in one of the worst global crises since WWII. As of this writing, over 87 million people have been infected worldwide, resulting in more than 1.8 million deaths.
- Precipitously imposed lockdowns across the globe resulted in a sharp, steep global recession as economic activity ground to a halt in the first half of the year. The US economy saw the largest quarterly GDP decline in history in Q2 2020, with the 31.4% decline quarter-on-quarter far eclipsing the worst of the Great Depression and Great Financial Crisis.
- As markets crashed in March – sparking fears of a global depression – the Federal Reserve and other major central banks mounted an unparalleled response. Banks issued emergency rate cuts, slashing interest rates to zero. Faced with a liquidity crisis that spread even to high-quality assets, the Federal Reserve vastly expanded its set of policy tools and chose to act as the buyer of last resort, actively purchasing a broad spectrum of fixed income securities including corporate bonds – an approach they purposefully eschewed during the Great Financial Crisis. Other central banks went even further, expanding these emergency purchases to include equity securities as well.
- Fiscal policy measures also greatly expanded over the course of the year. Politicians, faced with record decline in economic activity and surging unemployment levels, saw firing the proverbial fiscal bazooka as the only option on the table. The US passed a number of novel fiscal programs, including direct payments to households, in an effort to ameliorate some of the economic pain of government-imposed lockdown orders. In total, US fiscal policy programs amounted to more than 18% of 2019 GDP, dwarfing the policy response to the Great Financial Crisis in 2008-2009. The fiscal policy response in other developed nations in some cases exceeded 20% of prior year GDP, with Japan topping the list at 42.2%.
- The policy response meant to limit the spread of the virus decimated a number of industries but was a boon to others as the world adapted to a new reality. Global lockdowns crippled the travel and tourism industries, while many technology firms flourished. Many stock markets closed the year at or near record highs, seeing the combined wealth of the world’s ten richest people rise 57% to an all-time record high $1.14 trillion.
- Scientists worked tirelessly throughout the year in an attempt to develop a vaccine for the novel virus. Aided by government programs such as Operation Warp Speed, several vaccines were developed and approved for use before the year was through, a task many initially thought impossible in such a short time frame. These heroic efforts condensed a process that historically had taken a minimum of several years to achieve down to a few months, as a number of viable vaccines received widespread approval before the end of the year.
- The Presidential election in the United States smashed historical turnout records, with over 159 million Americans ultimately casting their ballot. Ballots cast in previous elections had never exceeded 140 million. It took a record of over 80 million votes for challenger Joe Biden to defeat the incumbent, Donald Trump. President-elect Biden’s victory marks the first time since 1992 that an incumbent President failed to win a second term.
- A record 141 women were elected to serve in the 117th Congress, representing 26.4% of its membership.
- The United Kingdom officially left the European Union at the end of January 2020, and a transitional negotiation period lasted the remainder of the year. Trade deal talks were contentious, but ultimately a deal was struck by the December 31 deadline.
- Israel signed peace deals with a number of Arab neighbors. The United Arab Emirates became the first Arab nation to officially recognize Israel, and several others followed. Additional peace deals look likely to come in 2021.
Markets post healthy returns
Despite these events, markets around the world ultimately posted healthy positive returns over the course of the year. The bellwether for US stock returns, the S&P 500, finished the year up 18.4% on a total return basis. Despite trailing for much of the year, small cap stocks, as represented by the Russell 2000, outperformed their large cap peers, with the index returning 19.96% after a strong rally in the closing months of the year. US equity performance varied widely by style, however. Growth outperformed value by the most on record for a calendar year, with the S&P 500 Growth Index returning 33.47% on a total return basis for the year versus the 1.36% return of the S&P 500 Value Index.
Performance also varied widely across sectors and industries. Information Technology led the way, significantly benefiting from the massive shifts that occurred in 2020 to finish the year up 42.21%. Energy was the laggard, suffering from a significant decline in demand due to global lockdowns, finishing the year down 37.31%. Performance was mixed internationally as well. The MSCI EAFE Index of major developed international equity markets returned 7.82% in USD terms. The growth style significantly outperformed value internationally as well, with the MSCI EAFE Growth Index returning 18.29% versus the -2.63% return of the MSCI EAFE Value Index in USD terms.
Emerging market equities significantly outperformed their developed market peers, with the MSCI Emerging Market Index returning 18.31% in USD terms. Looking globally, the MSCI ACWI Index, a proxy for the global stock market, returned 16.25% in USD terms in 2020. US dollar weakness during the course of the year was broadly a tailwind for US- based investors in international markets in 2020. In developed markets, the local currency return of the MSCI EAFE Index was just 0.84%, underperforming the US- dollar- denominated return by nearly a full 7%. The US dollar was not as strong against the broad basket of emerging market currencies, and the local currency return of the MSCI EM Index ended the year slightly higher than the USD return, at 19.12%. Several major domestic and international indices ended the year at all-time highs. The road to these returns was rocky, however, with average market volatility at the highest level since the Global Financial Crisis.
Fixed income markets made history in 2020 as well. As central banks around the world slashed interest rates in March, the yield on the 10-year US Treasury bond fell below 40 bps intraday for the first time in history. The sharp decline in rates resulted in strong performance from long- duration fixed income assets, which are more sensitive to rate moves, which offered one of the few safe havens during March’s market turmoil. The Bloomberg Barclays US Aggregate Bond Index, a broad measure of the performance of investment-grade fixed income markets in the US, returned 7.51% on the year. The ride was extremely bumpy, however; liquidity dried up across fixed income markets in March, and the index fell 15.57% from March 6 to March 20, which is more than five times the average intra-year decline over the past 25 years of about 3%.
Markets quickly stabilized once the Federal Reserve stepped in as the buyer of last resort, leading to a steady recovery in the months that followed. Returns were broad-based across sectors. Investment-grade corporate credit led the way, returning 9.89%. High-yield credit posted a slightly lower return of 7.11%, and was bested by the return on US Treasuries, which finished the year up 8%. Long- dated Treasury Bonds did the heavy lifting, finishing the year up 17.7%.
Internationally, dollar weakness also provided a tailwind for US- based investors. Developed market fixed income performance was slightly stronger, with the Bloomberg Barclays Global Aggregate ex. US Index returning 10.11% on the year. The bulk of this return was driven by currency movement, as the US dollar was down about 6.8% on the year against a broad basket of developed market currencies. Emerging market fixed income also had a strong year, with the return of the Bloomberg Barclays Emerging Market Aggregate Index finishing the year up 6.52% in USD terms. In a return to the environment throughout most of the 2010s, cash was the weakest performer on the year, with an all- Treasury bill portfolio returning a meager 0.54%.
Economic growth in 2021
The COVID-19 Pandemic
The global pandemic brought a swift end to the longest economic expansion on historical record in the United States in 2020. While the economy has begun to recover, near-term risks remain. The most important determinant of economic growth in 2021 will be progress in combating the virus. Winter has brought with it a resurgence in infections as families gather for holidays and spend more time indoors. This trend has been exacerbated by the emergence of a new strain of the virus that appears to be 50 to 70% more contagious based on the limited early evidence.
Despite this challenge, the vaccine rollout has begun, and vulnerable populations are currently being vaccinated. As mass immunization accelerates in the new year, we believe that the US will avoid a double- dip recession barring any complications with vaccine deployment. As we approach the level of herd immunity, which occurs when the level of people immune to the virus is sufficiently high enough to arrest the spread in the general population, the threat from the virus will be reduced, and we expect a strong resurgence in economic activity, targeted to begin in Q2 or early Q3. In particular, we expect a boom in consumer spending for high- contact consumer businesses, which account for the vast majority of the remaining output gap. Pent- up demand for these types of services is palpable in the idle chatter and small talk on Zoom calls. Once the population reaches herd immunity, we expect a sharp uptick in spending on those experiences that were out of reach during the efforts to control the spread of the virus. This spending will be supported by the current savings rate, which is abnormally high relative to historical levels.
This spending should also provide support for the labor market as workers are recalled in vaccine-sensitive industries and broader economic activity normalizes. We expect this spending to result in a transitory increase in inflation starting in the summer months, but the size of the global output gap and the significant amount of slack in the labor force suggests this inflationary pressure will not be sustained over the course of the next few years. Sustained inflationary pressure will require a significant tightening of the labor market, which we do not believe will be achieved until late 2024/early 2025.
This background provides for a strong economic growth environment in 2021 due to the shockingly limited damage from the pandemic to the supply -side of the economy. The unprecedented amount of fiscal policy support has lowered corporate bankruptcy filings below their pre-pandemic trend. The number of active small businesses has almost fully recovered – the result of a combination of business re-openings from temporary closure and a surge in new business formation. While we expect that some of the productivity- enhancing measures, born out of necessity in response to policy measures to control the spread of the virus, will see some reversal, many are likely here to stay.
Our base case is that a successful vaccine rollout will lead to a normalization of economic activity and an environment supportive of mid-single- digit economic growth for 2021. Risks, however, are skewed to the downside, and a resurgence in the uncontrolled spread of the virus would lower this growth estimate materially.
Turning to markets, the current stage of the economic cycle and the unprecedented amount of support for the global economy from fiscal and monetary policy create an environment ripe for strong asset returns in 2021. Classically defined, the typical equity cycle has four stages: “despair,”, “hope,”, “growth,”, and “optimism.”. The waterfall decline in the price of risk assets experienced in March 2020 was the very definition of the “despair” phase. Equity markets began to rebound during the summer, and the upward trend continued nearly uninterrupted for the remainder of the year, culminating in a strong post-election rally to close out 2020 – the “hope” phase. Those hopes came to fruition with the successful development of several effective vaccines in record-breaking time. In line with historical “hope” stages – during which the return of the S&P 500 has averaged 44% –- equity markets have experienced a sharp rebound since they bottomed on March 23. Alas, historically the “hope” phase, while having the highest returns, is also the shortest-lived, lasting a mere 9 months on average. With an acknowledgement that averages, and reality often diverge, circumstances indicate that 2021 will usher in the next phase of the equity market cycle. As the global deployment of the vaccines improves in earnest in 2021, the market cycle will likely shift to the growth stage. While equity market returns have historically been lower in the “growth” stage than in a “hope” phase (returns during a “growth” regime have been 16% on average), those returns have also been more durable, with the typical “growth” stage lasting 49 months.
We would be remiss if we did not acknowledge current valuation levels, however. The “hope” phase rally has pushed equity markets to above- average valuation levels on an absolute basis; this trend is to some degree also a function of record- low global interest rates and record- high global fiscal policy impulses. On a relative basis, however, equity valuations remain attractive. Looking internationally, valuations remain near or below historical averages. After more than a decade of stagnant returns, international equities have the potential to outperform their domestic counterparts for the first time in years, particularly in light of expectations for continued US dollar weakness, which acts as a tailwind for US- based investors.
The backdrop for fixed income markets in 2021 is a globally -synchronized easy monetary policy with no signs of tightening on the horizon. Against that setting and starting from a low-interest-rate base, government bond returns will likely be muted in 2021. Global yield curves will likely steepen over the course of the year, as economic re-openings increase global growth and raise inflation expectations, which will dampen the returns from longer- duration assets. We expect meaningfully higher returns from corporate credit, where default rates remain low due to fiscal policy support and cash flows that are expected to normalize over the course of the year. International bonds can provide an excellent diversifier as well and should also have a tailwind in a weaker US dollar, similar to international equities.
Potential recovery risks
Despite this positive outlook, as with any year there is no shortage of risks with the potential to upend our outlook over the course of 2021. The risk that looms largest is unambiguously the path of the COVID-19 pandemic. Our sanguine view on the global economy and markets in 2021 is predicated on the successful distribution and effectiveness of approved vaccines, which are expected to lower the risk posed by the virus and hasten a normalization of economic activity as populations approach herd immunity. Should the rollout effort hit any speed bumps, economic growth and asset returns will likely fall short of our expectations for the year.
Geopolitics provides an ever- present risk, and our focus over the next several years will be on the potential deterioration of US-China relations, the dual engines of global economic growth. Concerns over relations between the US and antagonists such as Russia, Iran, and North Korea are present as well. While we expect the Biden administration to largely revert to policy positions from the Obama era and work to repair international relationships that they have openly stated they believe have been damaged, antagonistic relationships will remain. Cybersecurity concerns should be at the top of the list. Failures in this area have the potential to cause significant damage to US business and economic interests in addition to their national security implications.
At the domestic level, single-party control of the Presidency and both houses of Congress increases the probability of antitrust investigations and the potential for regulatory intervention in the information technology sector, which could significantly impact the growth trajectory of the technology sector at large in the United States. But as our recap of 2020 shows, markets can continue to climb higher despite the headlines as long as economic and market fundamentals remain healthy.
As we begin the New Year, recession risk in the US is low and a strong pickup in global economic growth is expected. Monetary and fiscal policy will remain extremely accommodative across the globe, improving financial conditions both in the US and abroad. Against this framework, most broad asset classes are expected to generate positive returns. Progress against the virus and the potential impact of geopolitical tensions will be the key main events to monitor in the year ahead. While 2021 faces some potentially significant potholes that could generate negative headlines – as does every year – the experience of market investors in 2020 shows that markets can shrug off this noise and generate solid returns. It remains as important as ever to exercise sound investment principles and a high degree of diversification.
We remain committed to focusing on your long-term financial goals and priorities and constructing portfolios designed to reach those goals while minimizing risk. The volatility environment experienced over the last several years demonstrates the value of disciplined professional management.
The ups and downs in the market, exacerbated by the constant stream of headlines disseminating from 24/7 news networks, naturally elicit an emotional response. We humans are prone to behavioral biases, often overreacting to both downturns like the sell-off experienced in March 2020 and the strong returns that followed. In times like these, when dramatic headlines flow like water from a fire hose, determining the facts that matter and filtering out the rest is vital.
Our clients’ interests always come first, and our goal for 2021 is to continue to separate the signal from the noise and focus on what truly matters to the economy and markets to help you achieve your investment goals.