A reflation rally powered riskier assets to strong gains in Q4, with the Russell 2000® US small cap and MSCI Emerging Markets indexes leading the way. For 2020 overall, the sharp second-half recovery resulted in above-average, double-digit, full-year returns, with the S&P 500® and, again, emerging-markets equity out front. Assets generally perceived to be safer also prospered, as gold and long-duration bonds benefited from monetary stimulus and a drop in real yields, and all bond categories generated solid returns.
By several measures, 2020 represents one of the most volatile periods in history for US stock prices. The entire year was characterized by frequent, large, daily price swings in both directions, and implied volatility remained elevated throughout. Compared with other recessionary sell-offs in recent decades, 2020 also marked the swiftest drop as well as the quickest, sharpest bounce back to prior peak.
Despite the recent US surge in COVID-19 cases, financial markets continued to recover from pandemic- and recession-related declines experienced in the first half of the year. The cyclical outlook for most economies is constructive amid maturing recoveries, supportive policies, and with vaccine-assisted reopenings on the horizon. However, lofty asset valuations, combined with policy and inflation uncertainty, may keep volatility elevated in 2021.
See our interactive chart presentation for an in-depth analysis.
Economy/macro backdrop: Global business cycle in maturing recovery
The US and most other major economies entered 2021 in maturing recoveries. Some face near-term, virus-related headwinds, whereas China’s progress is advanced due partly to its quicker emergence from lockdowns. Activity remains below 2019 levels in most countries, but the prospect of a vaccine-assisted full reopening over the coming year has us constructive on continued broadening of the global economic expansion. In aggregate, US consumers are better situated to weather the near-term economic lull, making a double-dip recession unlikely, in our view.
The broad-based rise in prices for financial assets and housing boosted US household net worth by more than 10% from March to September of 2020. Consumers accumulated more than $1.4 trillion of excess savings during 2020 due to reduced spending plus income gains from fiscal stimulus.
Versus most past recessions, manufacturing activity in the US declined less and recovered faster than did services activity. The recent surge in new COVID-19 cases suggests that services industries and small businesses hit hardest by virus-related restrictions may continue to lose momentum over the rest of winter, leaving them far below normal activity levels but still well above the troughs experienced in the spring of 2020.
After 2020’s steep earnings decline, investors expect profits in the hardest-hit sectors to rebound sharply and for the overall market to fully reclaim its pre-pandemic earnings levels by the end of 2021.2 Earnings estimates were revised higher during the second half of 2020, helped by vaccine-related optimism. If earnings meet expectations, we could see a significantly faster recovery versus past recessions.
Headline CPI halved to 1% by year-end, primarily from weak demand and the deceleration in the shelter component of CPI. (CPI stands for Consumer Price Index.) Labor market slack remains high, with the employment-to-population ratio improved but still near its lowest point in more than 3 decades. Weak growth in wages and rents likely will keep inflation subdued in the near term, but a reopening boost may help sustain the 2020 rise in long-run consumer inflation expectations.
Government intervention and long-term inflation
Over the course of 2020, global central banks injected nearly $8 trillion of liquidity into financial markets. Most of this came in the form of quantitative easing (QE), helping support asset prices. The pace of balance-sheet expansion has lately been less forceful than it was at the beginning of the pandemic, but the Federal Reserve’s monthly asset purchases of $120 billion and its commitment to keep rates low continue to support asset-market liquidity.
At the end of 2020, the US government approved roughly $900 billion of additional emergency fiscal stimulus, providing important support to counter pandemic-limited economic activity. Absent additional support, the very large 2020 fiscal deficit is projected to tighten during 2021. Coupled with severe budget shortfalls among state and local governments, ongoing federal support may be needed to avoid a fiscal drag on the economy.
In winning control of the federal government, Democrats may be inclined and able to raise high-multiplier government spending. Fiscal multipliers—estimates of the increase in economic activity generated by fiscal stimulus—tend to be stronger during periods of easy monetary policy and economic weakness. High-multiplier spending may also be more inflationary.
We believe the longstanding global regime of relatively stable and investment-friendly policies, politics, and regulation is nearing an end. Rising populism, geopolitical destabilization, and de-globalization pressures are key drivers of this change. Over the longer term, we expect greater government intervention may inhibit corporate profitability, distort market signals, and lead to higher political risk in investment decisions throughout the world.
Recent decades’ dramatic worldwide rise in public and private debt, for instance, reflects monetary and fiscal policymakers’ proclivity to use low interest rates and government support in an attempt to boost growth rates. Meanwhile, deteriorating demographics among most advanced economies have been heightening fiscal pressure to increase pension and health care spending, and already elevated levels of government debt/GDP are likely to rise much further. We believe greater policy experimentation and “peak globalization” trends will eventually cause long-term inflation to rise faster than expected.
Asset markets: Continued broad-based recovery across asset categories
Almost all asset categories posted positive returns for Q4, with leadership shifting toward small-cap and value stocks, non-US markets, and sectors such as energy and financials. Even so, large cap US growth, including tech stocks, still finished atop the 2020 leaderboard. Riskier fixed income credit segments, such as high-yield and EM debt, maintained their strong rally in Q4, but long-duration bonds and TIPS were ahead for 2020 overall.
A bullish reversal in market sentiment in the second half of 2020, combined with easy monetary policies, catalyzed a sizable rise in asset valuations across most major categories. These valuations—from high P/E ratios for stocks to low Treasury bond yields—are among the most extreme on record. After 2 straight years of valuation-driven stock rallies, a strong earnings recovery could be critical to the outlook.
Price-to-earnings ratios across all major global regions finished the year well above their long-term historical valuation averages. Forward P/Es indicate expectations for the US to remain above its long-term average while non-US developed and emerging markets move back closer to theirs, suggesting a relatively favorable long-term outlook for non-US stocks. Despite depreciating for a third quarter in a row, the US dollar still appears relatively expensive versus most major currencies.
US 10-year Treasury yields rose about 20 basis points during Q4 but remained roughly one percentage point lower versus 2020’s start. Inflation expectations continued to recover and finished at their highest levels of 2020. Credit spreads tightened across fixed income asset classes for the third quarter in a row, with almost all categories ending the year below their long-term averages. During 2020, extraordinary central bank accommodation in both the Treasury and credit markets put downward pressure on rates and spreads, helping push bond yields in high-quality debt categories near their lowest levels on record.
The business cycle can be a critical determinant of asset performance over the intermediate term. Stocks have consistently performed better earlier in the cycle, whereas bonds tend to outperform during recession. While we believe a business cycle approach to actively managed asset allocation can add value, portfolio returns are expected to even out over the long term (>10 years), regardless of the starting point of the cycle phase.