Key takeaways

• News of a number of effective vaccines lifted a cloud of uncertainty and unleashed animal spirits.
• For investors who stayed the course in 2020, it was hard to go wrong with nearly all asset classes recording solid results.
• Pent up demand is likely to support a quick rebound by mid-2021 despite lasting damage to some sectors of the economy.

For the full year, almost all major asset classes ended up strongly

Lower political uncertainty, another COVID relief package, and news of a number of effective vaccines boosted confidence that 2021 would see a return to normal. Investors looked through near term weakness to bid up lagging asset classes, resulting in winners all around in the fourth quarter. The S&P 500® posted a robust 12.1% total return for the quarter but paled in comparison to the previously lagging Russell 2000 which returned over 30%. After rallying 40bps in the fourth quarter alone, investment grade corporate spreads tightened to 96bps, just inside of where they started the year. High-yield bonds tightened over 150bps to yield only 4.18% at the end of the quarter, leaving the index with little of its namesake income. 

For the full year, almost all major asset classes ended up strongly. COVID continues to weigh on real estate performance, and commodities also lagged, posting negative returns for the year. In contrast, global stocks benefited from a weaker dollar and ended up over 10%. A late rotation catapulted the Russell 2000 over the S&P 500® (+19.9% vs. +18.4%), but technology stocks continued to be in a league of their own with the NASDAQ up over 45%. Fixed income returns were solid with the Bloomberg Barclays U.S. Aggregate Bond Index up 7.5%. Credit’s fourth quarter rally propelled high-yield and investment grade corporates to record low yields, resulting in positive excess returns over comparable Treasury securities of 2.25% and 0.49%, respectively, for the year. Despite the strong positive momentum, equity markets continue to price in stubbornly high volatility. While inflation expectations have perked up, rates remain at historically low levels with even the 30-year bond yielding only 1.65% at the end of the year.

Investment grade spreads are back at tight levels, and yields are at all-time lows

“It was the best of times and the worst of times”

The Federal Reserve’s (Fed) intentions are clear – rates are to remain anchored near zero until inflation takes hold. The Fed remains committed to maintaining an aggressive pace of asset purchases, even as its balance sheet has grown by over $3.2 trillion since the end of February. Congress seems to understand that fiscal policy needs to play a leading role. The late passage of a new COVID relief bill provides for ongoing enhanced unemployment benefits, $600 stimulus checks, and continued aid for small businesses and transportation. At a value of $900 billion, while smaller than the $2.5 trillion CAREs Act, the package still weighs in at over 4% of Gross Domestic Product (GDP). Under the Biden administration, policymakers are likely to support actions that seek to drive growth until the tide lifts all boats. 

In the words of Dickens, “it was the best of times and the worst of times”. While COVID continues to take a real toll, the return to normal is likely to be far more robust than in previous recoveries. Unlike most recessions, the pandemic was an exogenous event. Quick regulatory approvals and an imminent vaccine rollout were game changers, lifting a cloud of uncertainty and unleashing animal spirits. 

Despite what is still the worst economic contraction in decades with consensus growth in real GDP of (-3.5%) for the year, it could have been far worse. When signs that the economy was stalling emerged in fourth quarter, Congress stepped up once again. While it remains the worst of times for more than 10 million workers who are still unemployed, aggregate personal income is higher than a year ago, a far different result than in previous shocks. Fiscal transfers and a lack of spending opportunities not only provided needed aid but increased the savings rate. Substantial pent up demand is the backdrop for a vaccine-driven return to normal next year. Investors are not the only people looking through to a normalizing economy. Manufacturing, both in the U.S. and globally, returned to expansion territory at the end of the second quarter in 2020.

With fiscal support, aggregate personal income continued to climb

While a strong rebound is likely, in our view we’re not going to return to the old normal. The pandemic accelerated trends that were already in place and focused an unflinching spotlight on imbalances and sectors with weak value propositions. Work from home is here to stay, and demand for office space and business travel may take years to recover. Bricks and mortar retail will never be the same. Financial services companies need to compete in a low return world, at least for now. Higher education will have to demonstrate a better value proposition for on-campus learning. The cat’s out of the bag as more patients opt for telemedicine over in-person visits. 

New business models will emerge, and some sectors could experience a painful transition as investment and infrastructure align in new ways, while other businesses benefit as supply chains realign. Even well-performing companies will feel pressure to leverage technology to increase efficiency and scale. These changes are likely to continue to provide investment opportunities. 

The pandemic bared the reality of unequal impacts with low wage, service workers suffering the most. At the same time, the “haves” have more flexibility than ever before. Low tax states with a strong quality of life are drawing attractive businesses, which sets the stage for tension between needed rebalancing and tax policy. Populism and political division are most likely here to stay. 

On the bright side, the economy has been surprisingly resilient, and strong growth will likely ease the transition. While markets seem fully priced and even overvalued by normal standards, the stage is set for good economic growth in the coming year. We expect the current slowdown to be short-lived, and ample liquidity remains a strong support. However, with markets fully valued and rates at rock bottom, we believe now is a good time maintain investment discipline.