2021 Investment Themes

By Hightower Bethesda on February 9, 2021

As we proceed into 2021, it is worth taking an opportunity to outline our expectations of the market and what areas we anticipate being winners and losers in what is certain to be an interesting (but hopefully not too interesting) year. Broadly, we are anticipating an improvement in both the COVID and economic situations, that should support the stock market in the near term. However, the outlook is less positive for international markets, as many countries are lagging in domestic stimulus and vaccine rollouts. At the same time, domestically, there are spots of concern that investors should be aware of in case these complications grow into obstacles.

COVID Outlook

While not explicitly an investing theme, our COVID outlook underpins all the other themes, so it’s appropriate to specify the assumptions we are making regarding the outbreak. It is worth noting, we are not making a forecast that deviates from the broader consensus. Vaccinations will increase through the first half of the year. Roughly around the middle point of the year, some combination of herd immunity and vaccinations will allow Americans and the economy to return to some semblance of normalcy. The broader developed world will lag the US slightly, and emerging markets will lag even more.

This forecast has significant downside risks, that could delay our public health and economic recoveries. Already, the domestic vaccine rollout is less-than-impressive; and, if it fails to accelerate, that could further delay the recovery. Alternatively, if the COVID virus evolves faster than anticipated, the efficacy of current vaccinations may not provide enough protection to allow a resumption of normalcy.

Shape of the Recovery

We do not anticipate this to be the 2009 recovery, where US GDP and employment growth was languid, and took years to surpass its pre-recession peak. Instead, we expect the US economy to surpass its pre-recession peak sometime in 2022. There are several factors that suggest consumption will rebound robustly, propelling the recovery into a higher gear. Remember, consumption comprises two-thirds of US GDP, so the strength of the American consumer is the strength of the US economy.

First, Americans are sitting on a lot of money. The combination of the fiscal stimulus and the “forced” savings of lockdown, the US savings rate is just below a record high. According to the Federal Reserve, the US savings rate was 13.7% in December 2020. For comparison purposes, this is well above the 7.5% rate from the previous year (still a historically elevated number) and more than four times the 4.1% savings rate in the December prior to the 2008 recession.

At the same time, credit utilization and consumer debt are both at manageable levels, especially relative to the previous recession. Likewise, record-high stock prices and rising house prices will induce spending through the wealth effect (the perception of increased wealth among consumers motivates more spending). Thus, the American consumer is well-positioned to increase spending quickly once the new normal allows it.

However, this forecast is not without risks. Certainly, such a rapid recovery does increase the risk of other issues (inflation, for example) that will be covered later in this article. And, fears about public health and the economy could linger even after the pandemic wanes, tempering the speed and size of the spending rebound; this is very dependent on how quickly the vaccine resolves the outbreak.

Cyclicals and the Rise of the Consumer

While a recovering US economy should support the broader stock market, inevitably some sectors are bound to benefit more than others. Naturally, cyclicals (those companies whose revenues rise and fall with the business cycle) should benefit the most from a rebounding economy. This bodes well for stocks in the consumer discretionary, commodities, and, to a lesser extent, financial sectors.

In particular, the rebound in the American consumer should support a rapid rebound in travel and entertainment industries – the so-called BEACH stocks; BEACH stands for bookings, entertainment, airlines, cruises/casinos, and hotels. In any recession, as consumers cut back on spending amid job cuts and a loss of confidence, there is an accumulation of pent-up demand due to delayed purchases. Given the relative strength of the consumer in this recession, once that pent-up demand is unleashed, the super-cyclical BEACH stocks stand to benefit the most (how many of us are eager to take a vacation once we’re able to?). As is always the case, there will be winners and losers within each industry. Without going into too much detail on individual stocks, some companies went into the recession on a stronger financial footing and positioned themselves for an inevitable recovery, while others were already struggling pre-recession, and the contraction only exacerbated their woes.

Now, the stock market is purportedly forward-looking, and many of these forecasts may have already been priced into the stocks. But, there may still be some investment opportunities, especially if economic or travel growth surprises on the upside.

Small Caps

This theme is a carry-over from the second half of 2020 where we felt the stabilization of the economy will allow small caps the ability to continue their recovery and eventually outperform large caps. For the better part of the last 10 years, the S&P 500 has been the driving force behind the growth of equities.  The Russell 2000 has performed admirably, but it has very much lagged in terms of relative return. For those who follow markets closely you know this is not the norm as historically small caps traditionally outperform large caps over time. Again, this has not been the case for the past 10 years ending October 2020 as the S&P 500 has gained a total of 196% while the Russell 2000 has only gain 119%.

Moving forward we feel a slight overweight to small caps will be prudent as a stable and improving economy, along with continued stimulus from the Biden administration generally favors small caps.  Also, we are believers in reversion to the mean when there is a catalyst, so the idea of large caps outperforming forever is unrealistic. From November 1 to January 31 the Russell 2000 has gained about 35% compared to about 15% for the S&P 500. This outperformance began immediately in November but has continued into 2021 where the Russell 2000 gained 6.3% in January while the S&P 500 was essentially flat. This still places small caps far behind when looking over the last 10 years (161% vs 201%) so we do feel there is a lot of runway left in this theme.

Large Cap Growth/Technology

Though we stated earlier that we like small caps over large caps, we still see a lot of strength coming from large cap growth and technology.  Technology companies provided outsized returns in 2020 and we expect that trend to continue in 2021, especially as it relates to what we consider “new tech.”

New tech are companies that have found a way to succeed in this new world we live in. This world was being developed before the pandemic hit, but it exploded because of it. The use of cloud computing services, digital signatures, cybersecurity, video conferencing, and digital payments were all being used, but not to the levels they are now, and not with the acceptance by mainstream users. Though the pandemic will eventually end, we believe many of these tools are here to stay, and they will be a part of our everyday lives. Furthermore, in an economic environment where slow growth is the norm, investors will continue to pay a premium for growth, so this segment should maintain its leadership status in 2021.

That said, like the internet/telecom boom of the late 90’s, there will be losers and investors need to be mindful of it. Though “first movers” generally have a leg up on the competition, technology is forever changing and improving so what looks great today might not in a few short years.

Sector Rotation

It’s hard to call the Sector Rotation Portfolio (SRP) a “theme” because it’s a constant part of our portfolio, but since we increased our base weighting in the second half of 2020 (from 15% to 25%), it’s worth noting what we see when we look at the recent trends inside of it.  Starting in the middle of 2020 building and construction was added to the portfolio which didn’t make clear sense then, but it does now. The pandemic has triggered a major housing boom in both new and second homes, as well as renovations. Most times the SRP is designed to recognize strength in segments of the market before they become completely obvious, and this was a great example of that.

More recently, the SRP dropped one of its technology positions (internet ETF to be specific) and added a position in a second clean energy sector.  This is not surprising to many as it has been clear that the Biden administration is looking to find ways to grow this segment of the energy market. We are unsure about what other policy changes may arise and who may benefit, but it most certainly will be interesting to see what sectors make their way into this portfolio this year.

Europe

Europe has been the quintessential value trap for investors for quite some time.   There was a head fake in 2018 when international equities outperformed domestic equities but that was short lasting.  In general, we have been underweighting Europe for a while and further reduced our exposure during the early days of the pandemic in 2020. Europe still faces an economic uphill battle due to their aging populations, socialist tendencies, and a fragmented economic system whereby their ability to provide mass stimulus in a time of need is not nearly as powerful as what we have in the U.S. This is a key reason the European banking industry still suffers from the fallout of the Global Financial Crisis and why they find themselves mired in yet another recession like environment coming out of the pandemic.

There continues to be calls from analysts that valuations in Europe are much lower than the U.S. which may be true, but unlike what we see in small caps, we do not see a catalyst for change and a subsequent reversion to the mean of historic returns. Keep in mind that for the last 10 years the Euro Stoxx 50 has gained a total of about 18% versus the Dow Jones 30 which has gained about 155%.  Point being, when/if, Europe can get their act together, handling their structural problems both demographic and economic, the opportunity set can be huge. We believe that day will eventually come, but do not believe that time is now and are very happy being “fashionably late” to the party.

Emerging Markets

Our outlook for emerging markets (EM) in 2021 is less sanguine than that for the developed world. Certainly, a global recovery combined with the expected rebound in commodity prices should benefit EMs. But, any advantage reaped from those trends might be offset by lingering pandemic issues. Unfortunately, EMs do not have the health infrastructure of the developed world; and, because of their poorer status, are at the back of the queue for access to the COVID vaccine. Thus, COVID-related complications should be a larger and longer drag on EM economies this year.

Over the longer-term, the performance of the EM space is dependent on the strength of the US dollar and commodity prices—both notoriously difficult to accurately forecast. A weakening US dollar benefits EMs in two ways: One, by making their exports cheaper in foreign markets, and two, reducing the cost of their debt (which is commonly held in US currency). At the same time, EM economies tend to be more commodity-focused, and will thus benefit from any increase in prices there.

Politics

After all the drama of the election, the Democrats have control of both chambers in Congress and the White House. Without delving too deeply into politics, here are a few observations we have:

• Historically a federal government controlled by a single party has led to less-robust returns in the stock markets. Markets have historically preferred the status quo that inevitably results from a mixed-party (and gridlocked) federal government.
• The Biden administration’s push for more fiscal stimulus is beneficial for a struggling US economy. As of this writing, the bill is still working its way through Congress, but we anticipate a bolstering of unemployment benefits, checks mailed to some Americans, and aid directed to state/local governments and small businesses.
• While the specter of higher taxes has some on Wall Street spooked, it is unlikely the Democrats will want to raise taxes in a still-nascent recovery. Further, once taxes are raised, the policy is expected to be targeted at corporations and higher-income households, limiting the economic fallout.

Fixed Income and Interest Rates

Domestically and internationally, we have been in a historically low interest rate environment for more than a decade. Given the current economic environment, these conditions will likely persist in the near future. Indeed, the Federal Reserve said they have no intention to raise interest rates until 2024, given their current economic forecast.

While we do expect interest rates broadly to inch higher as the economic outlook improves, these will be only modest advances and do little to provide the yield that income investors seek. Therefore, the Barclays Aggregate Bond Index—the most commonly used benchmark in the fixed income space—should post only a modest yield in 2021. As a result, some investors may hunt for yield, going down the credit quality ladder and accruing risk in an effort to get marginally better rates on their bonds.

While we likewise feel the pull of higher yields on these lower quality investments, investors need to be extraordinarily cautious when investing there. High-yield bonds inherently mean higher-risk bonds. With credit spreads narrowed from their recession highs, the marginal gain in yield may not compensate for the additional risk. While it is possible that the Hightower Bethesda Investment Committee increases its allocation to high-yield bonds, it will be with extra prudence and due diligence.

Inflation

Inflation is an interesting topic in the US, because inflation has not really been a concern domestically for more than 20 years. Simply, we do not anticipate persistent inflation to be an issue in 2021, or for the foreseeable future. To remain brief on a very complicated topic, the factors that have kept inflation at bay for the past decade are expected to persist over the next couple of years.

Having said that, there is the possibly of temporary flare-ups over the next year that might lead to a temporary spike in inflation. First, because of a brief period of deflation in April and May 2020, inflation may appear to run hotter in 2021 because of weak comparables; for example, even if the 2021 consumer price index remains unchanged from its current level, the year-on-year rate of change would still show an almost 1% gain in April 2021. Second, the aforementioned unleashing of pent-up demand might lead to a spike in inflation, as consumers rush to go on vacation, eat out at restaurants, and go to concerts; however, this is likely to be both temporary and sector specific.

While our forecast may sound too optimistic, it is generally aligned with the Federal Reserve outlook. The central bank has announced they are so unconcerned with inflation risks right now, that they have temporarily ceased trying to achieve their 2% year-on-year target and are instead focusing on developing consistent and robust employment (and broader economic) growth. To be sure, they are also aware of the potential for short-term blips but seem aware of their temporary nature.

Conclusion

With our expectations of a waning pandemic and a burgeoning recovery, our outlook for the US economy is measured optimism. The relative strength of the American consumer, combined with both fiscal stimulus from the federal government and monetary support from the Federal Reserve, should lay the foundation for a healthy recovery in 2021. However, the outlook is not without its risks, and there are certainly a few concerns we are actively monitoring. As such, these investment themes are less of a firm outline of an investment strategy, and more of starting point for a deeper conversation on high yield bonds, small- and large-cap stocks, and international investing. And, to be sure, as conditions change, it is certain that we will re-evaluate these forecasts, and adjust our investment portfolio accordingly. For more information on the current environment or our outlook, please talk with your advisor.

Sources: Federal Reserve Bank of St. Louis, Factset Financial Data and Analytics

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