The calendar is turning but the issues that have dominated the markets are likely to persist at least into the early part of the New Year. The good news: coronavirus vaccine distribution is underway worldwide.
The less good news: there are still several more months of winter to wade through, so that the virus will be with us for a while, and those industries directly impacted by the lockdowns – travel and leisure, for example – will likely continue to struggle.
In spite of this, we see the cyclical recovery continuing and possibly even accelerating as the year goes on. The risk to investors is that an improving economy generates excessive enthusiasm and that the equity market, as a discounting mechanism, gets too far ahead of itself on lofty expectations, triggering a correction. To put it succinctly, investors should be on the lookout for “buy the rumor, sell the news.”
After years of relative underperformance, market dynamics may finally begin to favor small caps and value over large cap growth. The dispersion has become huge – from the end of 2019 through November 6 of this year, the Russell 1000 Value Index returned about -8% compared to a positive return of 31% for the Russell 1000 Growth Index. Since then, however, value has pulled ahead, climbing about 9% through the first week in December compared to 2% for growth, as measured by the Russell indexes. The question on everyone’s mind is whether or not this is sustainable? We think it may be. As growth becomes more widespread, it becomes less valuable, meaning investors are less likely to pay a premium for growth. While we think that large cap growth stocks will continue to perform well, it is possible that value stocks may perform even better.
Longer term interest rates should begin to inch higher as the economy recovers but not dramatically so, and short-term rates should stay low. In this environment, fixed income investors should take a close look at liquid alternatives like merger arbitrage, which according to our research, have historically performed better in rising rate environments1. Historically, much of the risk mitigation from bonds has come from the coupon but with rates so low, we expect fixed income to be less effective as an equity diversifier. Or as Jim Grant of Grant’s Interest Rate Observer has put it, treasuries have morphed from a source of risk-free return to one of “return free risk.” Alts provided risk mitigation yet also participated in the market recovery during 2020. We think they’re likely to continue to play a similar role going forward.
The coming year could be a favorable one for international equities, on lower interest rates, more attractive valuations, and faster vaccine delivery. The consensus view is that the U.S. dollar, which has been declining in value against other major currencies, may weaken further as the global economy recovers and U.S. foreign policy becomes less combative under a Biden Administration. However, much of the weakness may already be reflected in the current value of the U.S. dollar. Regardless of direction, volatility is likely to remain.
Other trends to keep an eye on include capital market activity and M&A. Demand for initial public offerings (IPOs) looks set to continue, with companies like Airbnb and DoorDash receiving huge valuations in the public market. Special Purpose Acquisition Companies (SPACs) have continued to find favor with investors and represent an alternative source of capital fueling a range of transactions.
Return to “Normal” vs. the “New Normal”
The pandemic and the accompanying lockdown are dramatically re-shaping the nature of how we think about work. While some parts of the economy will return to the pre-Covid status quo as the vaccine allows the world to reopen, others are likely to be permanently changed – the “normal” versus the “new normal.” Opportunity lies in differentiating between the two.
In the “new normal” camp are secular developments like work from home or, to be more precise, work from anywhere. This has led to a migration of some workers away from high cost cities like San Francisco and has hammered the demand for central business district office properties. Post-pandemic, we expect some percentage of those workers will return to the office, providing a boost to office occupancy rates and a cyclical bounce for the asset class. We do not, however, expect office demand to reach pre-pandemic levels anytime soon.
Along similar lines, one can look at the trends reshaping the way in which we shop. The rise of online shopping at the expense of bricks and mortar retail was not a trend that COVID created, but it was a trend that definitely accelerated. That pendulum is one that seems unlikely to swing all the way back, even after we get back to anything approaching normal.
A New Administration for a New Decade
While the presidential election has now been decided, control of the U.S. Senate remains up for grabs pending the results of two run-off elections, both taking place in Georgia in early January. These are, as the pundits like to say, consequential. Among the issues hanging in the balance are the size and nature of the next round of fiscal stimulus, tax and energy policy, climate change, immigration, criminal justice reform, and a host of other matters of importance to investors.
In the wake of the November 3rd election, markets appeared to be pleased at the prospect of a divided government. In our view, they have not priced in the possibility of Democratic control of both the House and the Senate. Should that happen, we would expect to see expanded fiscal stimulus in the short run. Longer term, we foresee increased regulations and higher taxes on businesses and wealthy individuals, which could be a headwind for the markets. Possibly offsetting these challenges include more ambitious progressive goals of student loan forgiveness and additional steps to combat wealth inequality. Continued Republican control of the Senate would thwart many of the democratic wish items including an expansion of the single-payer health care system.
More growth for ETFs
Assets in U.S. exchange traded funds (ETFs) hit $5 trillion for the first time in 2020, up from about $4.4 trillion the year before2. This is an industry that continues to find ways to innovate and keep growing. If anything, the pandemic and Covid-related market disruptions have helped these funds further prove their value as investors looked to ETFs for tactical positioning and price discovery, especially during the worst part of the pandemic related sell-off in March of 2020.
In 2019, the Securities and Exchange Commission (SEC) approved passage of Rule 6c11, lowering the barriers to entry for new ETFs. Firms had until the end of 2020 to comply with the new rule meaning the impact of this should start to be felt in 2021 as more funds come to market. Areas of potential growth include ESG (environmental, social, and governance), where companies may benefit from the Biden Administration’s more favorably view of climate change; Active Non-Transparent (ANT) ETFs, which seek to replicate active management3 strategies in an ETF wrapper; and active fixed income. The growing use of model portfolios by advisors should continue to contribute to ETF industry growth. These portfolios held around $4.1 trillion in assets in September, according to The Wall Street Journal. That was up from $3.5 trillion at the end of 2019.
Other developments of note include the maturity of the thematic category and continued fee pressure, possibly moderated by the growth of active ETFs.
The prediction market
France’s Charles de Gaulle once wryly said about Brazil that “it’s the country of the future and always will be.” Whether or not that’s true, or even fair, it’s the case that annual predictions don’t always adhere strictly to the calendar.
Last year, we weighed in on five broad themes. These included the familiar ones of growth in liquid alts and ESG, actively-managed fixed income, and the introduction of more factor-based funds. We discussed the election but declined to predict the outcome. And, of course, 2020’s most significant development – the global spread of the novel coronavirus – was barely on the horizon.
Looking strictly at the markets, our forecast was pretty solid, and our expectations for the New Year represent, in many respects, a continuation of the major trends from the year past. The difference, of course, is the coronavirus, which has upended millions of lives around the world, exacting an enormous human toll. But through hard work and perseverance a vaccine has been developed and introduced in record time, a testament to scientific ingenuity. With luck, the New Year will be defined not by the continued spread of the coronavirus, but by its end, and by a return to something approximating normal – whether it’s the new one or the old. Like everyone around the world, we’re looking forward to that day.