November 6, 2020
Reasons for Optimism
Reasons for Optimism in 2021
“There is not a liberal America and a conservative America - there is the United States of America. There is not a black America and a white America and Latino America and Asian America - there's the United States of America.”
~ President Barack Obama
One attribute that differentiates the US from other countries is our system of checks and balances. This was a core principle that guided the outline of the US Constitution. While Presidents have specific powers, the effect a president can have on our daily lives is greatly overstated. With a divided government, new policies are harder to pass, and presidential powers are limited. This is not a mistake but by design.
Assuming the Senate stays Republican, the White House will be limited in what it can accomplish. Both candidates had promised to run large budget deficits with market participants focused on a “reflation trade”. Today, investors seem more interested in low taxes and the Fed's promise to keep interest rates low for an extended period. This also changes the calculus on the tax increases, fiscal spending, and, ultimately, the path of the dollar.
Senate Majority Leader McConnell said this week that a stimulus package should be passed before the end of the year. The news has renewed optimism that a divided Congress or a delayed election outcome will NOT push back a stimulus bill's passage.
However, a split Congress also reduces the odds for a huge stimulus package, which would have benefitted value over growth funds. Growth funds are now seen benefiting since they offer more opportunities for investors in a lower growth outlook.
Large increases in capital gains taxes also appear unlikely, and private health care insurance is expected to remain as it is. This, too, benefits technology and healthcare-oriented growth funds, most of which sit on large unrealized capital gains.
Investors should take comfort in knowing that equity market performance has been healthy regardless of which party controls the White House. A divided government is widely viewed as constructive for stocks, as negotiation is needed to enact public policy, and significant legislative changes must be agreed to by both parties. During the preceding six Blue Waves, the S&P 500 increased 56% on average. Over the last three Red Waves, the index rose 35%. During the periods of divided government (seven in total), the S&P500 rose 60% on average.
What we expect in 2021
Before the election, the economy, the impact of the virus, criminal justice, and race relations topped voter concerns. Before the onset of COVID19, healthcare, the environment, foreign policy and trade relations were top of mind. In 2021, assuming a vaccine is available, the economy is projected to grow at a +4.5% annual rate before returning to trend. In Q3, GDP climbed sharply, rising 33.1% quarter over quarter (q/q). This followed a 31.4% q/q plunge in Q2 and a 5.0% decline in Q1. The Q2 decline and subsequent Q3 rise were the largest of the postwar period. However, even though the percentage rebound in Q3 was larger than the percentage decline in Q2, total GDP in Q3 was still 2.2% lower than in Q1 and 3.5% below the peak in 2019 Q4. This represents a combination of pent-up demand and lost productivity, both which are likely to be recouped in 2021.
Corporate earnings continue to accelerate from a low base. If this continues, markets can begin to grow into what is often viewed as extended valuations. Managements that are providing guidance are increasingly upbeat about the 2021 outlook. Technology, cloud service, and e-commerce companies reported strong earnings in the third quarter, and we are seeing signs of other businesses normalizing as well. Financial service firms focused on M&A advisory, trading, and restructuring have seen a surge in activity. And the housing market continues to benefit from low rates, with new home sales up +32% year-over-year. For 2021, we see earnings for the S&P500 increasing to $150 vs. $116 in 2020, an increase of over +27%.
Early in Trump's presidency, his administration pushed for a reduction in the number of regulations in what was known as the "one-in two-out" policy. The program required that any additional costs from new regulations must be offset by an equivalent cost related to two existing regulations. In a Biden Administration, the regulatory environment is expected to resume an upward march, increasing the size of the government and along with it, the cost of compliance.
One area of agreement between the two parties has been a concern large technology companies had become monopolistic. Market strategists had assumed the Trump Administration would push to break up or at least curb the influence large tech companies can have, whereas a Biden Administration was expected to address competitive issues through increased regulation. Gridlock, however, makes any significant new antitrust legislation against the tech industry far less likely. Many of the concerns surrounding big tech, including issues of privacy, data manipulation, domestic security, and censorship, will remain. The NASDAQ finished November 4
5.78% higher. We believe funds positioned in stocks expected to generate a larger percentage of their earnings well into the future will continue to do well.
Interest rates fell sharply this week, with the yield curve flattening as the bond market pushed back the first-rate hike's expected timing. Under a blue wave scenario, analysts had predicted the Fed would be forced to raise rates sooner, due to rising deficits and reduced foreign demand for US Treasuries. Many analysts remain concerned over the expansion of the federal deficit, and its impact on inflation. Now, with fiscal stimulus expected to be scaled back by a Republican-controlled Senate, inflationary pressures have been deferred, at least for now. Most economists expect the Fed will continue to repress interest rates (what choice do they have) and eventually resort to Japanese style management of the yield curve. The decline in bond yields puts pressure on value funds and, specifically, bank stocks. Alternatively, there may be more upside for the housing market as mortgage rates are expected to decline further. The chart below shows the current slope of the current yield curve (bottom line) vs. the curve's slope at the beginning of 2020 (upper line). The 1.41 percent decline in yields on the short end of the curve (from 1.58% at the beginning of the year to just 17 basis points today) not only helped stabilize financial markets but will continue to be a powerful incentive to reallocate funds to securities other than low yielding fixed-income funds.
Before the election, the U.S. dollar narrative was that expanding fiscal deficits under Biden would accelerate weakness in the dollar. We believe the new Administration’s continued reliance on monetary policy will continue to pressure the dollar lower. If the dollar continues to weaken, countries whose debt is denominated in U.S. dollars -- especially those in emerging markets - will be net beneficiaries. The JPMorgan EM Fund (Ticker: JEMSX – red line in chart below) has now outperformed the total U.S. stock market by 28% since Oct 2018. All else equal, a weaker dollar (inverted: blue line in the chart below) supports higher prices of international funds.
The price reaction in Gold has been a mirror image of the action in the dollar. The Gold Trust iShares (Ticker: IAU) is up +4.26% for the week and +30.3% year-over-year. The spike in gold prices in 2020 to new all-time highs has been tied to decreasing real interest rates in the US. Combined with record levels of debt, the US dollar's reserve currency status will continue to be questioned. We view Gold as the
“currency of last resort”
, especially in an environment where governments appear determine to see who can debase their currency the fastest.
No party has a monopoly on the success of the U.S. economy, and investors should avoid making significant changes to asset allocation based on election results. With the noise of the election behind us, we believe the market and investors will return their focus to the fundamentals of earnings, valuations, and the efficient discounting of risk.