Key Observations
- Financial assets produced remarkable returns over the final nine months of 2020, characterized by rising equity valuations and narrowing credit spreads amid a global pandemic and a disjointed global economy.
- The global economy is poised to achieve strong year-over-year growth and modest inflationary pressures in the first half of 2021, which should benefit risk assets and spread sectors. Wide-scale vaccination efforts may be the link to more sustained economic growth as the year progresses.
- While it is uncertain if the market rotation that began in November will continue, we advise maintaining broad diversification within and across asset classes to ensure a portfolio does not unnecessarily hinge on any one economic outcome.
Financial Market Conditions
Economic Growth
Although global economic activity picked up in the second half of 2020 as economies emerged from strict containment measures, the pace of recovery may be poised to moderate sequentially (quarter-over-quarter). Policymakers remain vigilant against COVID-19, reinstating mitigation measures in some areas (e.g., Illinois, New York and Massachusetts) until vaccination efforts are able to play a more active role on the public safety front. Although the pace of economic growth is likely to slow quarter-over-quarter, year-over-year economic and earnings growth should rebound sharply in the first half of 2021, particularly in the second quarter. However, our base case expectation for 2021 is best described as a tale of two halves, distinguished by uncertainty about the ultimate pace of economic normalization.
Monetary Policy
Global central banks remain committed to using all tools necessary to reinforce the ongoing economic recovery and achieve policy objectives. Apart from temporary programs designed to alleviate financial hardships caused by the pandemic, the Federal Reserve, European Central Bank and Bank of Japan all reiterated plans to maintain asset purchase programs until individual economies meet their respective policy objective(s). That may change in 2021, should the bifurcation between monetary and fiscal policies diminish.
Fiscal Policy
The exogenous shock caused by the global pandemic exposed the limits of conventional monetary policy measures, which take time to work through economic channels and largely remain stuck in the financial sector, and pressured policymakers to respond decisively with unprecedented deficit spending. In the U.S. alone, the fiscal deficit grew $2.8 trillion from March to November as Congress attempted to ease private sector financial conditions hit hardest by lost income. Janet Yellen, President Biden’s nominee for U.S. Treasury Secretary and former Fed Chair, is familiar with the limits of monetary policy absent coordinated fiscal policy. Her nomination signals a potential merger between the Treasury and Fed to deliver targeted accommodation to the private sector if the economic recovery should slow.
Inflation
Through November, the Fed’s preferred year-over-year inflation measure, the Core Personal Consumption Expenditure Price Index (“PCE”), remained stubbornly low at just 1.4 percent, and long-term broad inflation expectations remain well-anchored. However, the impact of pandemic-induced stimulus and ongoing measures to alleviate the economic burdens on households (evidenced by a deceleration in the labor market recovery) may cause inflation to rise in 2021.
Currency
Following its dramatic run-up in March as investor appetite for risk plummeted, the trade-weighted U.S. dollar fell nearly 11 percent by late December (the year-over-year decline was a more subdued 3 percent). In 2021, the U.S. dollar may continue to encounter downward pressures given the current configuration of domestic monetary and fiscal policy, which could ignite opportunities (and higher valuations) in tangible assets and international equities for U.S. investors.
Fiducient Advisors 10-Year Capital Market Assumptions
The resiliency demonstrated by capital markets during the last nine months of 2020 was remarkable and certainly welcomed by investors in an otherwise challenging year. Gains achieved across many asset classes influence and inform our most recent efforts to recast our capital market expectations, and elevated valuations inhibit our forward-looking return assumptions. The table below summarizes our 10-year return estimates and demonstrates the higher hurdle (and lower expected returns) that are by-products, largely, of the last three quarters’ worth of strong risk asset returns.
The Federal Open Market Committee (FOMC) took its policy interest rate to zero in the first quarter of 2020, which drove bond prices higher and subsequently reduced our return expectations across fixed income. Our bond return expectations are further constrained by credit spread levels, which narrowed from April through December on reopening optimism and demonstrable progress toward a vaccine. Strong global equity returns in 2020 resulted in elevated equity valuations to start 2021 and lowered our equity return expectations 0.3 to 1.6 percent.
We have also reduced our return expectations for real assets and alternatives, although these asset classes continue to offer important diversification benefits within a thoughtful portfolio construction exercise. Changes to hedge fund and private equity forecasts are tangential to changes in public fixed income and equity return assumptions.
The information contained herein is confidential and the dissemination or distribution to any other person without the prior approval of Fiducient Advisors is strictly prohibited. Information has been obtained from sources believed to be reliable, though not independently verified. Any forecasts are hypothetical and represent future expectations and not actual return volatilities and correlations will differ from forecasts. This report does not represent a specific investment recommendation. The opinions and analysis expressed herein are based on Fiducient Advisor research and professional experience and are expressed as of the date of this report. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice. Past performance does not indicate future performance and there is risk of loss.
