by Craig MacKinlay
As last month’s issue of Partner Talk highlighted, 2020 is a year all will remember. The costs of the pandemic in terms of widespread loss of life and illness will never be forgotten. Further, as a result of the pandemic, many parts of the economy were shut down leading to a year that was a laggard from an economic perspective. For the entire year 2020, Gross Domestic Product (GDP) fell by 3.5 percent. This decline represents the largest annual decline in economic activity since 1946 when GDP declined by 11.6 percent.
The past year did include one positive surprise – the behavior of financial markets. With the significant decline in economic activity, a natural inference would be that a drop in the values of financial assets would accompany this economic decline. However, such a drop in values did not happen. Indeed, while the markets did decline sharply at the onset of the pandemic in March, markets were strong for the calendar year as a whole. The stock market as measured by the S&P 500 Index increased by more than18 percent. The bond market as measured by the Bloomberg Barclays US Aggregate Bond Index increased 0.67 percent. (This low bond market return is mostly related to the current low interest rate environment as opposed to being pandemic driven.)
The opposite direction of the change in economic activity relative to the movement of prices in the markets have led many to conclude that a delinking between the economy and markets occurred. Such a phenomenon would be troubling since the link between markets and the economy is a central tenant of economics. However, drawing such a conclusion is premature. As observed in March when the pandemic first hit, markets are partially influenced by current economic activity. However, the magic of markets is the forward-looking characteristic that they exhibit. With most valuation models, future earnings expectations are more important for the determination of value than current earnings. A reasonable explanation for the apparent delinking is that market participants expected the influence of the pandemic to be temporary and not significantly impact future economic activity. It is important to take a forward-looking view to assess what the future might bring.
Real economic growth as measured by GDP was negative for 2020 with the current reading for the year at -3.5 percent. The past year’s growth was a tale of two halves. The overall negative growth was driven by declining GDP in the first two quarters of the year. In a reversal, the second half of the year exhibited strong positive GDP growth with the third quarter growing at 33.4 percent and the fourth quarter growing at 3.5 percent. Looking forward to calendar year 2021, the positive growth trend from the last half of 2020 is expected to continue. But the uncertainty associated with the resolution of the pandemic is evident in the broad range of available forecasts. These growth forecasts range from approximately 3 percent to 5 percent with the consensus forecast about 4 percent.
As an example, consider the real GDP forecast of The Conference Board, a known and respected non-profit business membership and research group organization. The Board expects growth at 4.1 percent for 2021, with 2.0 percent growth in the first quarter. However, the Board emphasizes the dependence of the forecasts on uncontrollable factors including “(1) the scale of the ongoing COVID-19 resurgence and any resulting lockdowns, (2) the deployment and effectiveness of COVID-19 vaccines, (3) the size and timing of fiscal stimulus, (4) the status of labor markets and household consumption, and (5) the degree to which volatility in the US political transition affects consumer and business confidence.” Because of the unknown impact of these factors, the Board also provides an upside growth forecast of 6.1 percent and a downside forecast of 0.8 percent for 2021. The continuing presence of a high level of uncertainty for economic growth is apparent.
Inflation forecasts for 2021 generally range from 1.8 percent to 2.2 percent. The Federal Reserve has recently changed its policy to set two percent inflation as a long run target level, implying that two percent inflation is a long run goal and inflation above two percent will not necessarily lead to an increase in the target funds rate. Thus, this policy combined with modest economic growth suggests that in the coming year, the likelihood of a fed funds rate increase is minimal.
Unemployment continues to be an issue. In January, total nonfarm payroll employment increased by 49,000, and the unemployment rate declined from 6.7 to 6.3 percent, according to the U.S. Bureau of Labor Statistics report on February 5. These changes are a positive, but the effects of the coronavirus and efforts to contain it continue to impact employment. Many sectors including leisure and hospitality suffered significant job losses. Higher unemployment and an economic slowdown are possible until the vaccine becomes more widely available.
Turning to equity markets, earnings per share on the S&P 500 for 2020 declined by more than 16 percent relative to 2019. However, earnings are expected to bounce back in 2021 with first quarter growth projections of 19.6 percent and projections for calendar year 2021 of 23.6 percent. While these forward-looking year-over-year growth forecasts are strong, they are benefitting from being compared to a very weak 2020. Further, the uncontrollable factors noted above with respect to economic growth and the accompanying uncertainty also apply to the earnings outlook.
A driver of the performance of the fixed income market is the path of interest rates going forward. As noted above, if the Federal Reserve maintains its current view, rates are likely to stay low and bonds are likely to have a low but positive return. However, the current low interest rate environment does limit the upside for fixed income. If the economy achieves its forecasted solid growth, corporate bonds should outperform government bonds albeit with greater risk.
In summary, looking forward, the prognosis for the economy as a whole and for the corporate sector is relatively positive. But uncertainty due to pandemic related issues continues to be present. Beyond the direct impact of the virus on the economy, it is likely that lower government revenues combined with higher spending will result in large deficits. Such deficits put downward pressure on market values and upward pressure on inflation and interest rates. Because future market movements are impossible to predict, the best action plan is to carefully control portfolio risk with a goal of achieving high risk-adjusted performance.