News and Commentary

Market Update January 2021 By Joseph Karl, CFA®

We are one month into 2021 and much of the uncertainty from the previous year remains, even as the distribution of COVID-19 vaccines begin to roll out and a new administration takes the lead in Washington, D.C. While it is difficult to predict precisely where the economy will head this year, there are certain factors we can consider to help frame our investment decisions and navigate these challenging times. Despite these heightened levels of uncertainty, we remain optimistic and believe 2021 and the years to come will produce strong gains economically.

The COVID-19 Virus

Predicting the trajectory of the economy must start with an assessment of the virus and the prospect of containing transmissions, which is required before social and businesses restrictions can be lifted. As of today, the FDA has approved two vaccines for emergency use authorization (EUA), with two more pending EUA in the next few weeks. Despite this incredible level of progress, the ultimate test of a vaccine’s success will depend on the efficiency of distribution and its long-term efficacy in light of virus mutations.

The Economic Cycle

It has been less than one year since the COVID-19 virus brought an abrupt ending to the longest economic expansion in U.S. history. We are now back to the beginning of a new economic cycle, typically marked by high unemployment, infusions of government stimulus, and concerns about an uncertain future – all of which are present today. While we do not want to downplay these concerns, and we recognize that it is difficult to draw historic parallels with today’s challenges, history has proven that it is a losing game to bet against the U.S. during uncertain times.

Congress and The Biden Administration

On Jan. 20, amid an ongoing pandemic and a deeply divided political climate, Joe Biden was inaugurated president of the U.S. as Democrats took control of Congress. One of the top items on Biden’s agenda is a $1.9 trillion COVID-relief package, which, if passed into law, would become the third round of government-backed economic support for individuals and businesses that continue to struggle in the wake of the virus.
From a historical perspective, the U.S. government has traditionally implemented substantial stimulus programs in response to severe economic challenges, such as the New Deal after the Great Depression and the building of the national highway system after World War II.
Congress passed the first two rounds of COVID-related stimulus in 2020 to prevent the economy from deteriorating. Today, unprecedented stimulus proposed by President Biden and supported by a Democrat-controlled Congress could offer a clear path to get the economy back up to pre-COVID levels quickly. Although such a large government-relief package will increase the federal deficit and put pressure on the government to eventually increase taxes, the focus today is and should be on giving the economy the boost it needs to get back to full speed as quickly as possible.

U.S. and China Relations

It will be interesting to see how the Biden administration will carry out its plan to be “tough on China,” as trade tensions between the world’s two largest economies have escalated in recent years. It is further expected that China’s economy will continue to grow and challenge, if not surpass, the U.S. for global supremacy within the next decade. While a quick separation between the two countries would create broad challenges for the global economy, a slow and measured decoupling could be beneficial with both countries working to ensure their separate economies are strong for leverage and negotiating purposes. Additionally, a decoupling could lead to more jobs returning to the U.S. and a more domestically driven U.S. economy that is more responsive to monetary policy.

Technology

One positive result of the pandemic has been the rapid, forced adoption of new technology, both in business and in our personal lives. Prior to the pandemic, technological advancements, such as 5G and artificial intelligence (AI), were poised to give the economy a significant boost. The pandemic accelerated this theme by not only forcing consumers and businesses to adapt to new technologies but also ushering in a greater willingness for them to embrace the adoption of these new tools. We believe that this greater reliance on technology will allow the U.S. to allocate time and resources more efficiently post-pandemic, making the country more productive and ultimately leading to higher economic growth in the future.

The Federal Reserve

As Congress debated the merits of proposed stimulus packages, the Fed responded to the virus immediately with accommodative policies that we expect to continue in the future. In doing so, it followed through on its mission to avoid letting politics get in the way of delivering support when it is needed. The chart below illustrates the Fed’s financing of government spending via quantitative easing and holding U.S. treasuries on its balance sheet (blue line), and the impact on the Federal Budget deficit (red line).
Source: Yardeni
We can look at recent events to identify clues for what the Fed may do in the future.
In the Fall of 2020, the Fed updated its policy to move towards average inflation targeting, which provides it with a runway to remain accommodative for a longer period. Fed Chair Jay Powell followed up that action stating that the federal funds rate will remain at the lower bound until at least 2023. The recent confirmation of former Fed Chair Janet Yellen as Treasury Secretary highlights the need for coordinated efforts between fiscal and monetary policy as we try to navigate these uncertain times.
Despite the broad array of economic challenges and risks relating to the pandemic, we have faith in the resilience of the U.S. economy and its ability to pull through these difficult times.

Equity Markets

In 2020, U.S. equities, on average, produced strong returns despite a contentious election year and the uncertainty created by the virus and resulting blow to corporate earnings. Some of the factors contributing to these positive results included optimism over the development and rollout of a vaccine and proactive stimulus from both the Federal Government and the Federal Reserve. Yet, it can be argued that the most important influence on returns has been the market’s forward-looking nature.
Entering 2021, we have some sense of resolution to many of the concerns from the past year, including the development and distribution of vaccines. However, we remain mired in other challenges, such as high unemployment, political divisiveness, and a general overvaluation of equities given last year’s strong gains despite a blow to earnings.
Source: JP Morgan
With the high valuation of stock prices and continued economic uncertainty, one must ask whether all optimism is priced into the market, or if the market has further room to run. The lack of similar parallels in history makes this question even more difficult to answer, but we remain optimistic for the following reasons:
  1. We are at the beginning of a new economic cycle when returns tend to be relatively strong.
  2. Biden’s proposal to deliver additional government stimulus backed by a Democratic majority in Congress and an extremely accommodative Federal Reserve should help to support optimism and expedite an economic recovery rather quickly.
  3. Stocks relative to bond yields are not overvalued, and, with the Fed’s accommodative policy, bond yields will remain low and help provide extra support for equity markets.
To get a better gauge of where returns could be headed in the future, we can break them down to create four scenarios based on assumptions to changes in valuations, earnings growth, and dividends.
Base Case
Assume vaccine distribution is successful and new strains of the virus do not create additional challenges. By the middle of this year, vaccine distribution could support herd immunity and allow social and business restrictions to be removed. Additional stimulus and pent-up consumer demand should allow the economy to return to normal relatively quickly and support corporate earnings to come in as expected at +22.41 percent. The Fed’s accommodative short-term rates and quantitative easing program should help to keep equity valuations above their long-term averages. Under this scenario, we would expect returns of 7.2 percent (22.4 percent earnings growth, -17.2 percent valuations, dividends of 2.0 percent).
Optimistic Case
Assume vaccine distribution is far more efficient and effective than currently projected, and further rounds of stimulus and pent-up demand jump-start the economy. Despite a quicker-than-expected recovery, we would expect the Fed to maintain its very accommodative stance through 2021 to ensure a full recovery. Corporate earnings should come in 10 percent better than expected, with valuations declining from current levels but remaining elevated from continued optimism. Under this scenario, we would expect returns of 23.7 percent (33.9 percent earnings growth, -12.2 percent decline in valuations, and 2.0 percent in dividends).
Longer Recovery
Assume distribution of the vaccine continues to be relatively inefficient, causing many restrictions to remain in place and keeping economic confidence low. However, continued government stimulus could help bring modest improvements to the economy and prevent a double-dip recession. Under this scenario, we would expect earnings to recover roughly half of the rate currently expected (+11.2), valuations to decline to two-thirds of their long-term average (-17.2%), and for dividends to remain level at 2 percent, resulting in a total expected return of -0.4 percent.
Pessimistic Scenario
Assume inefficient distribution of vaccines that are less effective with further strains of the virus, forcing the government to keep some restrictions in place. Challenges with the virus and the government response would continue to weigh on consumer confidence despite continued stimulus measures. Corporate earnings would remain level in 2021 from the extremely low 2020 levels, and valuations would decline meaningfully to below long-term averages as concerns over a stimulus package’s viability would undermine confidence. Given continued economic uncertainty and weakness, corporations would have to cut their dividends. Under this scenario, we would expect returns to -24.8 percent (0 percent earnings growth, -25.8 percent, 1.0 percent dividends)
While we would not be surprised to see bouts of volatility or a correction at some point this year, we do believe 2021 will continue to produce attractive returns for equities despite relatively high valuations. Furthermore, we expect that a combination of an accommodative Fed and the willingness of the incoming Biden administration to provide additional stimulus, as needed, will continue to provide the support necessary to get the economy back up to speed relatively quickly, and the optimism around the strength of the recovery will continue to support equity prices.

Fixed Income

The yield on the 10-year Treasury started the year at 0.93 percent, well below the long-term historical average, but above the all-time lows reached last year. For diversified investors, bonds will always play a critical role in a portfolio but expected returns going forward will almost certainly be lower than they have been in recent years and below long-term averages. Given the current lower-yield environment and the inverse relationship between bond prices and interest rates, the qualities of price and cash flow production that bonds typically provide in a portfolio are likely to be lower than they have been historically.
For 2021, we expect the Fed to keep interest rates low while a Democratic-controlled Congress will help to push through President Biden’s policies and calls for additional fiscal stimulus. While both these factors will help to boost the economy (rather than simply sustaining it), it is important to note that at some point additional stimulus will increase inflation expectations and consequently lift interest rates higher, especially at the longer end of the curve.
Given the higher sensitivity of longer-maturity bonds and the flatness of the yield curve, we recommend a shorter-term positioning of bond portfolios to reduce interest rate sensitivity. We also believe the Fed’s accommodative policies will support credit markets and keep credit spreads relatively tight, suggesting that exposure to credit will add value relative to traditional treasuries.

Conclusion

It is difficult to draw historical parallels with the challenges we face today, but the extent of those issues and the current degree of uncertainty provides policymakers with an opportunity to be extremely accommodative. The new presidential administration combined with a unified Congress and an accommodative Federal Reserve provide the foundation policymakers need to act and deliver necessary stimulus to get the economy back to full speed as quickly as possible. The United States has a proven track record of overcoming adversity that provides us with an optimistic outlook and the belief that we will see significant economic improvements in 2021.
About the Author: Joseph Karl, CFA, is chief investment strategist with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email info@provwealth.com.
Provenance Wealth Advisors, 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.
Joseph Karl, CFA, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors and Accountants. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of the advisors of PWA and not necessarily those of Raymond James. You should discuss any legal matters with the appropriate professional. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Every investor’s situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary.
There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Past performance may not be indicative of future results. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. The above hypothetical examples are for illustration purposes only. Actual results will vary. Future performance cannot be guaranteed, and investment yields will fluctuate with market conditions. Diversification does not ensure a profit or guarantee against a loss.
Source
1.   FactSet Earnings Insight