While the successful vaccine distribution effort in the United States hints at an eventual return to normal, TIAA Investment Management Group (IMG) believes that uncertainty will remain with us for some time to come. This is evident as Europe, Canada and other parts of the world continue to grapple with hiccups in vaccine distribution, and countries such as India and Brazil find themselves in crisis, due to a resurgence of the virus. Political discord and social unrest in the United States, Hong Kong, Myanmar and other regions also continue to fuel a sense of instability around the world. While these and other concerns are reflected in IMG’s cautiously optimistic perspective for the markets and economy in 2021, there are also reasons for optimism as we enter the mid-cycle of the economic recovery.
2021 key themes
IMG has identified three transformational themes that it believes will continue to influence personal, business, planning and investment decisions for the remainder of the year. These include the evolution to a post-pandemic world, an extended period of low interest rates and continued market volatility.
1. The Great COVID Evolution
While 2021 promises to offer an end to both the pandemic and economic crisis, the toll for individuals, families and business owners has been profound and the after-effects are likely to be long lasting. According to John Canally, Jr., CFA, IMG Chief Portfolio Strategist, these health and social issues have a ripple effect, impacting the economy, markets, and individual investment decisions. For example, school closures continue to affect the labor market, with parents forced to choose between working and supervising at-home students. Many businesses have indicated they will continue to allow all or a portion of their employees to work remotely, and the significant shift to online commerce that we saw early in the lockdown, which will likely persist beyond the end of the pandemic.
“Over the past 12 months, the parts of the global economy that could function during a pandemic have done so and are thriving,” Canally said.
Global manufacturing has staged a V-shaped recovery as has the U.S. housing market, thanks to shifting demographics, low interest rates and consumer preferences migrating toward the suburbs. A V-shaped recovery occurs when an economy is able to quickly rebound and return to its pre-recession state, generally following an equally dramatic downturn.
2. Lower for Longer
As the markets fell in early 2020, the Federal Reserve (Fed) acted swiftly to lower interest rates to ensure liquidity and the ability for markets to function during a time of increased uncertainty.
However, the expectation for continued fiscal and Fed stimulus, aimed at boosting economic growth, raised the potential for inflation and a resulting decrease in the value of bonds. For example, as interest rates rose during the first quarter of this year, bonds posted negative returns for the first time in 40 years. Even if things turn around, lower rates are expected to persist for some time to come.
“This means that bonds may not provide as much income in the current environment as they have historically,” said Canally. “Instead, investors should view bonds primarily as a way to help protect against equity market drawdowns and potential inflation, rather than as a significant source of income.”
While hitting absolute return targets in the current low return environment will be challenging, in terms of risk-adjusted returns, IMG believes bonds are still efficient. Maintaining allocations across multiple high-quality bond asset classes and sectors helps to balance equity risks and improves diversification.
3. Volatility is the New Normal
In addressing recent equity market volatility, it’s important to recall how we got here. At this time last year, the markets were just beginning to recover from the steep, 34% decline in the S&P 500.
“We’ve experienced an 83% rally off of that low1 with a lot of bumps along the way, which all seem relatively small by comparison,” Canally said.
These “bumps” included selloffs in June and September 2020, followed by another brought on by third wave fears in the winter, as well as an early spring correction due to inflation fears. Canally expects this volatility to persist in the weeks and months ahead as long as the disagreement over rates continues between the Fed and the markets.
While economic data, politics and monetary policy headlines may generate market volatility in the short term, in the long term, earnings growth is the key driver of equity returns. We saw this last year as earnings bottomed out in July 2020, only to move up steadily since then. According to Canally, this pattern is typical as the economy transitions from recession to recovery in the early phase of the business cycle. He notes that we saw a similar pattern coming out of the 2008-2009 recession.
“As the expansion matures, forward earnings estimates flatten out and may decline as the economy moves into mid-cycle,” he said. “Going forward, we can expect to see months or weeks when earnings estimates are lower, which is totally normal for this stage of the recovery.”
Where we’re headed
Taxes and job growth will play a significant role in driving the markets and economy in the months ahead, with taxes expected to dominate the discussion during the second half of the year. In fact, a central theme of the Biden campaign platform was a massive infrastructure bill which would be paid for with higher taxes.
“This should not be a surprise to markets,” Canally said. “This platform has been out there for nearly a year, and the markets are up roughly 15 to 20% since President Biden was elected in November.” However, Canally warns that what a candidate or president proposes is just a proposal until Congress creates and passes legislation, which can take some time.
“Right now, the proposal is to take corporate tax rates from 21% to 28%. However, before all is said and done, they could go to 24%, 25% or even 30%,” Canally said. “Conversely, we may not see any tax increases at all, or we might see a repeal of the state and local real estate tax exemption.”
According to Canally, it’s too early to know what will happen with taxes, so it’s a mistake for investors to guess at tax policy or make investment decisions based on proposals that may not materialize until much later in the year, or never.
Canally also expects progress on the job front to play an important role in the months ahead. At the end of April 2021, the U.S. unemployment rate was 6.1% and the non-accelerating inflation rate of unemployment (NAIRU) was 3.8%, which is relatively close to where the Fed thinks the unemployment rate will be in the long term (4.0%).
“The Fed has made it clear that they want this gap to close completely so that everyone can participate in the recovery, before they will consider raising rates,” Canally said. “That will take some time and is a significant reason why we expect to see a continuation of the Fed’s lower-for-longer posture.”
What does this mean for the fixed-income markets?
Canally believes opportunities for higher yields and return potential will continue to exist, although they may be accompanied by increased risk. As a result, how the bond portion of a portfolio is structured will look somewhat different than in the past.
Maintaining allocations across multiple high-quality bond asset classes and sectors helps to balance equity risks and improve diversification. Where appropriate, IMG is allocated to investment grade corporate bonds, structured credit, emerging market bonds and U.S. high-yield bonds via the use of active management and customized portfolio construction.
While inflation risk is still relevant, it’s expected to be less of a concern for the next several years, due to continued Fed intervention. While 1970s-style inflation is not expected, some increase in core inflation (i.e., excluding food and energy) is anticipated and could become an issue longer term.
“If inflation increases, the Fed may raise rates, or it might continue to repress rates for some period of time as a means of trying to mitigate inequality, even while the market starts pricing inflation into spreads,” Canally said. “Even a short-lived inflationary spike could hurt struggling companies if they need to refinance debt when inflation has increased their borrowing costs.”
Where can equity investors expect to find value going forward?
While corporate earnings have moved up steadily in recent months, Canally anticipates earnings estimates to flatten out as the economic cycle matures and we enter the mid-cycle of the recovery.
“Stocks remain near all-time highs despite recent dips,” he said. “While we expect volatility to persist in the months ahead, the probable end to the health crisis by mid- to-late summer should help distressed parts of the economy and distressed assets stage a strong recovery bolstered by unusually good household fundamentals.”
The challenge for investors going forward will be building portfolios that deliver durable income and total returns for the balance of the decade. As a result, IMG’s equity investment themes center on looking for quality across geographies, sectors and industries. In particular, IMG believes:
- U.S. small caps appear relatively undervalued and favor emerging market equities given the likelihood of a weaker dollar
- Dividend-paying (and growing) companies appear attractively valued in an ongoing low-rate environment
- U.S. small caps offer value, and we are favorable toward emerging markets equities
- Companies focused on environmental, social responsibility and governance (ESG) criteria should continue to do well in 2021
- New deals will remain scarce in the private equity markets
What should investors be thinking about now?
The months ahead may be challenging for investors, marked by continued volatility and the likelihood of near-term market selloffs. On the plus side, stock prices have been highly resilient in recent months and have recovered quickly from declines.
“Worse-than-expected economic growth would be a negative for our modest risk-on positioning,” Canally said. “Likewise, the intense and sharp rallies in lower-quality stocks that we saw immediately after the U.S. election would be a risk, as we are looking for a more normalized trading environment in 2021.”
Eric Jones, Senior Manager Director of Advisory Solutions at TIAA, believes the current environment continues to support the importance of having access to an experienced and knowledgeable financial steward guiding your wealth planning decisions. Similar to last year, a disciplined investment management process will be critical for driving investor outcomes in the months ahead.
“In 2020, as global uncertainty and unprecedented volatility gripped the markets, it was really important for us to engage with and educate clients on what was going on and how we, as investment managers, were responding to this rapidly changing environment,” Jones said. “We took advantage of numerous opportunities for tax loss harvesting and rebalancing, while much of our thought leadership and client engagement efforts centered on helping investors assess their risk tolerance to determine if it was still appropriate or if they needed to make adjustments.”
While last year was an example of all of the things that people worry about happening all in one year, Jones emphasizes that even as the economy recovers, lingering uncertainty makes it necessary for investors to continue to engage with their advisors as market and economic conditions evolve. That includes ensuring your planning is up-to-date and reflects any changes in your circumstances, risk tolerance or goals.
“As we saw last year, your financial plan not only provides a valuable roadmap for the future, but a structure you can draw upon to buffer, secure and optimize your assets during times of change or increased volatility,” Jones said. “While change is inevitable, anchoring yourself in a plan can help ensure you’re in a better position to weather change and stay on course toward accomplishing your goals.”