- Looking out to 2021, the single, largest factor that will shape the trajectory of near-term economic growth will be the timeline and effectiveness of any vaccine, which, if widely available by mid-next year, could revive some sectors of the economy.
- The presidential election has been decided, but markets are also looking ahead to the Georgia Senate runoff in January to see if a single party will hold the White House and both congressional houses. The outcome could impact regulatory policies and future fiscal stimulus.
- In terms of monetary policy, the Federal Reserve is unlikely to raise rates in the near term or until inflation averages 2 percent for a sustained period and the unemployment rate falls markedly.
This month’s main article covers what the market implications may be in 2021.
Handicapping the New Year: 2021 Outlook — Reading the Risks
Jose Sevilla, Senior Portfolio Manager
It’s been an eventful year, to say the least, most recently punctuated by an election that will usher in a new president and new party into the White House. President-elect Joe Biden takes office in January, but it is yet to be determined whether he will lead the country with a single-party, holding a majority in both congressional houses, or if we will have a Democrat-controlled House of Representatives and a Republican-led Senate. We will not know the answer until January when control of the Senate will be decided by runoffs for both Georgia Senate seats. In the interim, there are some important questions to consider: What do investors need to know about the situation, and what are the market implications for 2021?
If it turns out to be a split Congress, the baseline expectation is that there will be no sweeping changes to the tax code and the regulatory environment. In this scenario, it is also anticipated that a second COVID-19 stimulus package will be smaller than if the Democrats also gain control of the Senate. In addition, it is also reasonable to expect that Biden’s infrastructure spending plans and other priorities will be scaled back, if support is needed from a Republican-controlled Senate.
A divided Congress has historically been good for equities. Looking at past performance, per Dr. Ed Yardeni’s blog on November 2, 2020, he indicated that the S&P 500 has increased 60 percent on average during periods of a split government vs. 56 percent when Democrats had full control and 35 percent when Republicans reigned.* Of course, congressional control is just one factor, and it’s important not to lose sight of the additional variables in play that will shape the US economy and markets in 2021.
No doubt the most obvious and important factor will be the effectiveness of any vaccine. If one is widely available by the middle of next year, the sectors that have been hardest hit by the pandemic should expect some recovery. And if there’s any additional fiscal relief, the economy should get another boost. However, even under an optimistic scenario for the distribution of a vaccine, it will take time for the economy to rebound to pre-pandemic levels. Even after the impressive third-quarter rebound, the economy is still growing at a rate well below its potential. Inflation is not likely to impact monetary policy in 2021, especially given the Federal Reserve’s new policy guidelines.
The Fed has reiterated that it will not consider raising rates until inflation averages 2 percent for a sustained period and the unemployment rate (currently under 7 percent) falls to a level consistent with full employment (pre-pandemic unemployment was 3.5 percent). If the inflation outlook changes quickly in 2021, the Fed could alter other policies before it signals its intent to raise interest rates. For example, the Fed could reduce the pace of its quantitative easing (i.e., its purchase of Treasuries and mortgage-backed securities) and also possibly extend the duration of its buys.
At the moment, we see the market backdrop as supportive for investment grade credit going into 2021, due to a combination of strong liquidity, improving US economic growth and the rapid vaccine development to date. If COVID-19 vaccines are approved and become readily available, many troubled sectors — including restaurants, travel and leisure and brick-and-mortar retailers, among others — are expected to begin contributing to overall economic activity. US economic growth has already rebounded from the second quarter of 2020 and is trending in the right direction.
Most corporations appear to have enough liquid assets to provide insurance, in the event markets and profits deteriorate. This reflects the record-breaking amount of new debt issued in 2020. And if we are to assume no sweeping changes to the regulatory environment and tax code, the situation bodes well for corporate issuers.
Of course, any outlook should also acknowledge the risks. The biggest would be if the markets have overestimated the efficacy or the timely dissemination of a vaccine. Another risk could be the possibility that a stimulus package does not get passed or is too tepid to provide meaningful support to the economy. If either of these circumstances occurs, we may see growth slow and unemployment rise. This would result in an equity market sell-off, a flight to quality and lower corresponding Treasury yields, and wider credit spreads. Furthermore, the Primary and Secondary Market Corporate Credit Facilities are set to expire by the end of 2020, leaving us to wonder if the lifeline to the corporate credit markets will be extended to support markets in the event of another downturn.
Overall, we see 2021 as a potentially more challenging year for investors. It is apparent that where the economy and markets head from here not only depends on the new administration, but also on the development of a vaccine, the size of the next stimulus bill and the future of fiscal and monetary policies. Given the wide range of potential outcomes, we continue to take a disciplined approach to duration management to remain flexible should volatile conditions resurface. We also continue to overweigh spread product, as the fundamentals and technicals remain supportive, despite the uncertainty surrounding the pandemic.
Jon Schwartz, Senior Portfolio Manager
It appears that the shock to our economy — and our entire pandemic way of life — may finally be ending sometime in 2021. If reports of an effective vaccine are not exaggerated, 2021 stands to be a year of continued recovery. But those expectations are based on a few unknowns that have yet to play out, and plenty of challenges await the new presidential administration.
Many of the rosiest predictions for growth in 2021 are predicated on a robust and supportive fiscal policy to sustain those on expiring unemployment benefits, as well as to encourage consumer spending that appeared to be slowing late in the year. No fiscal package was agreed upon before the election, so the next administration will need to look for ways to spur this economy.
As we move beyond the election, it’s helpful to review what was expected and what has transpired. The market was clearly anticipating a blue wave that did not fully materialize, though there is a chance that one party will still control both houses of Congress and the White House. Two key components of the Coronavirus Aid, Relief, and Economic Security (CARES) Act are set to expire at the end of the year, including Pandemic Emergency Unemployment Compensation (PEUC), which provides protection for those who don’t typically qualify for unemployment like the self-employed, and Pandemic Unemployment Assistance (PUA), which provides an extension to current unemployment benefits. This underscores the urgency for a broad spending package in early 2021. The Fed has called for fiscal stimulus, as there is only so much monetary support the Fed can provide. Therefore, we believe that continued growth will be dependent on a supportive fiscal package.
Controlling the curve
As for the remaining levers the Fed can pull to spur economic growth, look no further than the shape of the yield curve. The Fed can influence the front of the yield curve by moving the Fed funds rate, but it has been very clear and consistent in its messaging. Without inflation hitting and remaining above its 2 percent target for “some time,” Fed policy is unlikely to become less accommodative in the next few years. In other words, don’t expect any rate hikes soon.
Another area that the Fed can impact is the middle and back of the yield curve if the Fed deems it appropriate to increase the maturities of its asset purchase programs. The November Federal Open Market Committee (FOMC) minutes highlighted the potential for weighted average maturity (WAM) extension for the Fed’s Treasury purchases, but this seems more an issue for debate as opposed to a true signal for any immediate action. If the Fed expects growth to be slowed by higher interest rates further out the curve, the Fed can simply adjust its purchases to coax down these interest rates. Remember, the Fed can buy US Treasuries with an “unlimited” capacity, so if the committee deems long-end rates to be too high for borrowers, then the Fed will buy more bonds to control the shape of the curve. The December Fed meeting is the next opportunity for the Fed to mention yield-curve control, and we’ll be watching closely for any indication of changes in the asset purchase programs.
It’s not just about fiscal stimulus and Fed policy. There are old faces in new roles, which could also shape the economic recovery in 2021. Former Fed Chair Janet Yellen is due to become Treasury Secretary, which might ultimately bode well for the success of a robust fiscal stimulus. Although she does not have a vote in the Senate, her history of being a vocal advocate for fiscal support is positive for the size and timing of any spending package.
Looking at the jobless data, unemployment claims worsened for the second week in a row as of November 21, which is the first two-week downward trend since July. The surge in COVID-19 cases and hospitalization rates is having an impact on this economic data, and state-instituted curfews along with increased restrictions on indoor social activities are curtailing new hiring. The slowdown in the employment outlook continued into November as the increase in payrolls was the lowest since the pandemic began in March. November nonfarm payrolls data show that improvement has moderated with 245,000 jobs added vs. the expected 469,000 new jobs. The unemployment rate dropped to 6.7 percent in November from 6.9 percent in October. Clearly, there are reasons to be thankful this season, but with case counts and hospitalizations increasing, the economy doesn’t have the “all clear” yet. Nevertheless, most of us will welcome the start of 2021 with open arms.
Tim Lee, CFA, Senior Credit Research Officer
Thanks to the pandemic and the short, sharp shock it gave to the economy in the second quarter, the streak of three consecutive years of improving agency credit ratings within the US investment-grade universe will come to an end this year. On an annual basis since 2017, rating upgrades have outpaced downgrades by an average rate of 145 upgrades for every 100 downgrades, a 1.45 Up/Down ratio, based on ratings changes made by Moody’s. In 2020*, the script flipped, and downgrades outnumbered upgrades, with the Up/Down Ratio dropping to 0.79. In other words, for every 79 upgrades there were 100 downgrades. This is not a great trend, but it was not altogether unexpected. In fact, one might marvel at the overall credit health of the investment grade universe, given the severity and unusual set of circumstances.
It’s important to note that rating changes have not been universally negative this year, and this reflects the disparate financial effects that COVID-19 has exerted on the economy. Three sectors – technology, communications and financials – recorded Up/Down ratios above 1.0, indicating there were more upgrades than downgrades. In part, this reflects the positive benefits that accrued to the technology and communications sectors from the increase in remote work and online activity during the pandemic. Meanwhile, cautious provisioning, conservative capital levels and regulatory changes implemented since the last recession have helped banks remain relatively stable this year. In addition, the fixed income, equity trading and investment banking units of some banks have benefitted from pandemic-triggered market volatility and monetary easing.
Conversely, pandemic shelter-in-place orders were a primary catalyst for downgrades in the consumer cyclical sector, as demand for travel-related services were dented, traffic at non-essential retailers was restricted, and sales at car dealerships fell. The energy sector was also hit hard by stay-at-home mandates, as the closure of schools, offices and entertainment venues sapped demand for gasoline, diesel and jet fuel. As a result, crude oil and natural gas prices hit all-time lows and depressed energy company cash flows.
In contrast, energy was one of the better performing sectors during the 2008–2009 recession, with an Up/Down Ratio of 1.1 vs. an anemic 0.5 in the current COVID-19 environment. The financial sector, a relative bastion of calm this year, represented 83 percent of all downgrades in the US investment grade universe in the one-year period ending June 2009. Interestingly, the communication and technology sectors fared just as well during the last recession as they have during the current recession, with Up/Down Ratios of 1.7 and 1.4 respectively, compared to this year’s 2.0 and 3.0 ratios. Nonetheless, the previous recession was much harsher on the US investment grade universe, with an overall Up/Down Ratio of 0.17, indicating there were 5.8 times as many downgrades as upgrades, vs. 2020’s Up/Down Ratio of 0.79.
Looking ahead, the pace of downgrades and negative rating actions should slow, as strong liquidity and prudent financial policies help US investment grade companies maintain their credit profiles amidst a potential economic rebound in 2021. All told, the credit environment has experienced just mild symptoms to date, given the severity of the pandemic.
Jason Graveley, Senior Manager, Fixed Income Trading
It’s difficult to reconcile the all-time highs in equity markets with a mixed bag of economic data and surging COVID-19 cases in many communities. There is a sense of market euphoria, with headlines heralding the venerable Dow Jones Industrial Average crossing 30,000, while at the same time economic indicators all point to a much more grinding economic recovery. Unemployment, in particular, still hovers around 7 percent. Still, momentum and hope are serving as the key driving forces and shaping investor sentiment.
Investors appear to be pinning their hopes on an effective vaccine and additional fiscal stimulus. The vaccine news has buoyed markets, instilling a degree of confidence in a return to long-term normalcy. Investors have largely shrugged off the latest headlines of increasing cases, hospitalizations and the specter of new lockdowns and instead have embraced a potential light at the end of the tunnel. The prospect of renewed fiscal spending has further alleviated some short-term concerns. As a result, investors appear comfortable adding more overall risk to their portfolios, and both equity and credit markets reflect that.
Will embracing risk come back to haunt investors? Where we go from here is never easy to discern, but there are a number of variables to weigh and questions to answer. These include the policy implications of a new president, an ever-evolving vaccine timeline and a scheduled Senate runoff that will determine if one party controls both houses of Congress. Regardless, the 2020 turnaround that we have seen in markets since the emergence of the pandemic has been nothing short of remarkable.
Corporations, looking to shore up their balance sheets and avoid any short-term liquidity crunches, responded to low yields across the curve by extending duration through longer-term debt issuance. This left a large buyer base in the front-end credit market while supply was contracting. This dynamic remains in place today, as each event risk refocuses attention there.
Credit spreads remain anchored at their lowest levels of the year, with few catalysts pushing yields wider and plenty of investor cash looking to opportunistically purchase on relative value. Bond yield forecasts do show an expected steepening across the curve in the medium term, pointing to a return to normalcy and the prospect of future rate hikes as early as 2022. However, current Treasury rates remain under 20 basis points (bps) inside of two years. The next monetary policy pivot is a matter of debate, and in uncertain markets a disciplined investment strategy is what best serves our clients’ interests. We continue to stress diversification, high-portfolio credit quality and duration management, helping to generate market returns without sacrificing liquidity. This appears to be the best way forward in the near term, should all this market optimism fade in the new year.
|Treasury Rates:||Total Returns:|
|3-Month||0.07%||ML 3-Month Treasury||0.01%|
|6-Month||0.09%||ML 6-Month Treasury||0.02%|
|1-Year||0.11%||ML 12-Month Treasury||0.05%|
Source: Bloomberg, Silicon Valley Bank as of 11/30/20