Capital Markets Commentary | Investment Outlook 2021
This Investment Outlook updates Ellwood’s asset classes views expressed in our Mid-Year Investment Outlook, published in July 2020. The world will be in a period of transition during 2021—optimistically moving from alarming levels of COVID-19 infections to a growing percentage of the population vaccinated. While we will not be surprised by bouts of volatility including larger equity drawdowns, Ellwood sees a continuation of the economic recovery, buoyed by supportive monetary and fiscal policies.
We are generally sanguine about equities, albeit apprehensive about the concentration of high valuation, technology/internet stocks in large cap indexes. Seeking to diversify this concentration is a strategy worth considering in 2021.
Within fixed income, we have downgraded our view on investment grade bonds based on a combination of very low yields and expectations for rising inflation. While the break-even inflation rate (the implied future inflation rate priced into Treasury bonds) has already increased, Ellwood continues to see Treasury Inflation Protected Securities (TIPS) as a sensible alternative to nominal Treasury bonds. Credit markets rallied after a sharp sell-off in early 2020, and with a normalization in spreads, a more broadly diversified credit basket including corporate, securitized and emerging markets is an appropriate strategy.
For alternative strategies, Ellwood has upgraded our view on real (i.e., inflation-sensitive) assets, reflecting our view on escalating inflation. Private credit remains an attractive option within a diversified credit portfolio to gain exposures that are unavailable in liquid markets. Ellwood’s more favorable views on equity, credit and real assets tilts allocations away from hedge fund strategies. Real estate allocations should be deliberate and targeted as we continue to anticipate a wide dispersion of COVID’s impact on property types over the coming year. Finally, investors in private equity should continue to commit at levels targeted within pacing models.
Economic Growth and Inflation
Economic growth experienced stunning levels of COVID-driven fluctuations during 2020, with real GDP in the U.S. falling -31% and rising 33% in the second and third quarters, respectively1. We anticipate a continuation of the economic recovery into 2021, which is also reflected in the Federal Reserve’s latest real GDP projection of 4.2% for 20212.
Ellwood anticipates inflation expectations to rise during 2021 as the global economy recovers and the Federal Reserve, as described in its December 2020 Federal Open Market Committee Statement, “…aims to achieve inflation above 2 percent for some time…”3. The Fed’s inflation projection, as measured by the Personal Consumption Expenditures (PCE) Index, its preferred measure of inflation, for 2021 is 1.8%, well above the most recent reading of 1.1% but still below its 2% target2,4.
Monetary and Fiscal Policy
Ellwood fully expects the Federal Reserve to maintain its accommodative interest rate policy stance during 2021—even in the face of rising inflation—as its updated monetary policy framework allows for inflation to rise above its 2% target5. All seventeen participants in the Fed’s December 2020 Summary of Economic Projections anticipated no change in the Federal Funds Rate for 20212. While the Fed’s projections do not specifically include its asset purchase program (aka quantitative easing), for the time being we are comfortable assuming they will continue their purchases of Treasury and mortgage-backed securities throughout 2021.
In late December 2020, a $900 billion U.S. stimulus bill was signed into law to provide, among other support, a $600 stimulus check, additional unemployment benefits, and small business support through an extension of the Paycheck Protection Program6. As of this writing, party control of the U.S. Senate is still undecided; the outcome has implications for how the market will price in the probability of an increase in corporate and/or personal tax rates.
Asset Class Valuations
Asset prices rallied after a sharp sell-off in risk assets in the first quarter, resulting in higher valuations across most asset classes. Within equities, capital appreciation was driven by valuation expansion as earnings growth was broadly negative across regions. Investment grade fixed income returns were primarily driven by falling yields, as the 10-year Treasury yield fell by 1 percentage point. However, returns for high yield corporate and emerging markets were driven primarily by coupon returns, as spreads ended 2020 roughly where they started at the beginning of the year. In U.S. commercial real estate, cap rates on an absolute level are the lowest since the inception of the data series in 1982. However, cap rates look attractive relative to the paltry yield on 10-year Treasury bonds. Like in the public space, private equity buyout multiples are elevated, driven by deals in the software sector.
Risks to the Outlook
Ellwood’s Economic Cycle Dashboard assists in monitoring a range of leading indicators (including measures of economic activity, employment, credit conditions, spreads and liquidity) to evaluate the durability of the economic cycle. While the dashboard has materially improved since the nadir in April, there continues to be uncertainty regarding the path of economic growth over the next several months.
Evaluating prospects for economic growth in this environment is clearly challenging as it is highly dependent on the ability to control the trajectory of new COVID-19 infections, through both restrictions and vaccinations. While we are hopeful regarding the vaccines’ efficacy, there could be material downside risks if the vaccines prove ineffective, experience safety issues, or encounter significant constraints on production or distribution.
While Ellwood doesn’t anticipate changes in the Federal Reserve’s interest rate policy during 2021, we leave open the possibility that the Fed could telegraph adjustments to quantitative easing later in 2021. In particular, a slowing of asset purchases—even if launched in 2022—would likely be disruptive to markets when announced.
China may also resurface as a market mover for 2021. It is not yet clear whether the incoming U.S. administration will strike a tone of competitive coexistence or a tough approach that rekindles concerns over a new escalation of a trade war.
Uncertainty remains unusually high and conditions could change rapidly. Ellwood will continue to monitor the investment environment and make adjustments to our views as necessary and appropriate.
1. Bureau of Economic Analysis
2. Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/newsevents/pressreleases/monetary20201216b.htm, represents the median projection of participants in the Federal Open Market Committee’s Summary of Economic Projections.
3. Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/newsevents/pressreleases/monetary20201216a.htm
4. U.S. Bureau of Economic Analysis, Personal Consumption Expenditures: Chain-type Price Index [PCEPI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/PCEPI, December 29, 2020.
5. Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications-statement-on-longer-run-goals-monetary-policy-strategy.htm
6. Library of Congress, https://www.congress.gov/bill/116th-congress/house-bill/133/text
7. Board of Governors of the Federal Reserve System (US), Assets: Total Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level [WALCL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WALCL, December 29, 2020.
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Asset Class Valuation Percentile Ranks chart index information (page three). U.S. Equity P/E is P/E Trailing 12-Months EPS from 1970-2020 and is represented by the MSCI USA index; Int’l Developed Mkts P/E is P/E Trailing 12-Months EPS from 1970-2020 and is represented by the MSCI World ex USA index; Emerging Mkts Equity P/E is P/E Trailing 12-Months EPS from 1995-2020 and is represented by MSCI Emerging Markets Index; 10-Yr Treasury Bond Yield is 10-Year Treasury Constant Maturity Rate from 1962-2020 and is represented by the 10-Year Treasury Constant Maturity Rate; U.S. Corporate Inv Grade Spreads is option-adjusted spread from 1989-2020 and is represented by BloombergBarclays U.S. Corporate Investment Grade Index; U.S. Corporate High Yield Spreads is option-adjusted spread from 1994-2020 and is represented by the BloombergBarclays U.S. Corporate High Yield Index; Emerging Markets (USD) Spreads is option-adjusted spread from 2000-2020 and is represented by BloombergBarclays EM Hard Currency Aggregate Index; U.S. Buyout Multiples is the annual EV/EBITDA median from 2006-2020; U.S. Commercial Real Estate Cap Rates is Transaction Cap Rate less the 10-Year Treasury Constant Maturity Yield from 1978-2020 and is represented by NCREIF Property Index.
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Investments in securities are subject to investment risk, including possible loss of principal. Investments in international securities, even though publicly traded in the U.S., may involve risks which are in addition to those inherent in domestic investments.
Bonds are subject to interest rate, price, and credit risks. Generally when interest rates rise, bond prices fall.
Investments in emerging markets may be less liquid and more volatile. Additional risks include currency fluctuations, and political instability.
Equity investments are more volatile than bonds and subject to greater risks. Small- and mid-cap stocks involve greater risk than large-cap stocks.
High-yield fixed income securities are subject to liquidity and credit risk, and tend to be more volatile than investment grade fixed income.
A real assets strategy is subject to the risk that its asset allocations may not achieve the desired risk-return characteristic, underperform other similar investment strategies or cause an investor to lose money. The risks of investing in REITs are similar to those associated with direct investments in real estate securities. Property values may fall due to increasing vacancies, declining rents resulting from economic, legal, tax, political or technological developments, lack of liquidity, limited diversification and sensitivity to certain economic factors such as interest rate changes and market recessions.
Bank Loans are subject to greater levels of credit risk and liquidity risk than certain other securities. Leveraged loans are considered predominately speculative with respect to the issuer’s continuing ability to make principal payments. A downturn or period of risk aversion could adversely affect the market for leveraged loans and reduce an investor’s ability to sell its securities.
Alternative investment products, such as hedge funds, private equity, venture capital, private credit, real estates and real assets, are speculative and involve risk. Only investors who understand, and are willing and financially able to assume, the risks of such an investment—including the risk of losing all or substantially all of their investment—should consider investing. Additional risks to consider before investing in alternative investment products include the fact that some products may use leverage that may increase the risk of investment loss, can be illiquid, may involve complex tax structures, and are subject to limited regulatory oversight. For a more detailed discussion of the risks involved with an investment in an alternative investment product, please review the offering materials for the relevant alternative investment product prior to making an investment.
Published January 8, 2021