Wrapping up a tumultuous 2020, we peek at what 2021 may bring. We see reason to be optimistic and just as much to be cautious, and we think a balanced portfolio of styles and asset classes is likely to suit the possible outcomes.
As we turn the page on an unforgettably challenging year, the outlook for 2021 is brighter, thanks largely to remarkable vaccine progress—but significant challenges remain. COVID-19 cases are surging and the CDC recently issued a warning that this winter could mark “the most difficult time in the public health history of this nation.”¹
While the economic recovery that began in the second quarter has continued, we’re likely heading for a rough patch as we await widespread vaccinations. As with our multi-asset views in Market Intelligence, we want to embrace asset classes that can weather the pandemic-related challenges while seeking appreciation opportunities in a post-COVID-19 world.
Follow the earnings growth
With equities, we concentrate on forward-looking earnings estimates, as prices and profits usually move together. Global earnings revisions are improving, with the United States and China showing the strongest recoveries. We see less robust improvements in non-U.S. developed markets. They have heavier exposure to the financials sector, which will likely be challenged amid a continuing negative rate environment. We like overweighting the United States and emerging markets in a global equity portfolio. We’re also moving down in market capitalization in the United States to mid caps to capture improving earnings estimates, particularly from the industrials sector.
A two-pronged approach to factors: value and quality
The nuanced economic backdrop heading into 2021 is also influencing our factor calls. We favor value, which may have just begun to realize its significant catch-up potential after a long streak of underperformance versus growth. But near-term economic damage from the virus may limit the ability of cyclical value-oriented sectors to sustain their current pace.
As such, we’re maintaining exposure to quality, which includes well-capitalized companies with superior profit margins that are more likely to weather short-term economic challenges. We see blending these two factors as getting quality at a reasonable price. On the negative side, we believe momentum is a particularly risky factor, with stretched valuations and weightings toward bubble-like stocks. Meanwhile, the low-volatility and high-dividend factors held up relatively well in the drawdown earlier in 2020 and appear less suited for a potential economic recovery.
Sectors: two for value, two for quality
Heading into 2021, we’re focusing on technology and communication services for quality and healthcare and industrials for value. Technology and communication services have better profit margins than the overall market and earnings have been resilient amid the pandemic. On the value front, healthcare is trading at a 25% discount to the market ² on a forward price/earnings multiple basis and industrials stand ready for a substantial earnings recovery after a difficult year. Combining these four sectors gives us balance across global equities and the ability to participate, and potentially outperform, in various market outcomes.
Bonds will turn boring
After two impressive years for bonds, malaise may set in. The U.S. Federal Reserve (Fed) is likely to keep interest rates at zero, resulting in better return potential in intermediate-term strategies. In addition, investors will likely need to turn to corporate bonds for return potential. The Bloomberg Barclays U.S. Aggregate Bond Index, heavily weighted in U.S. Treasuries and mortgage-backed securities, is yielding 1.2%,³ its lowest ever. We think a blend of corporate bonds in the A, BBB, and BB rating tranches can provide better yield potential around 2.0% to 3.0%, so we’re targeting investment-grade and higher-quality high yield. We want to limit the amount of equity market risk associated with our bond portfolio, so we’re not abandoning duration or higher-quality allocations; instead, we’re tilting fixed income toward corporates with intermediate duration.
Cash won’t cut it
Market and economic uncertainty often lead investors to flee to cash—and that they did in 2020, in droves. Money market funds have taken in a remarkable $800 billion in 2020, according to Morningstar Direct, surpassing taxable bonds at $396 billion of inflows and U.S. stocks at $260 billion of outflows. The challenge? The Fed is likely to keep rates pinned near zero for the foreseeable future in order to help spur economic growth, making cash real returns (returns after inflation) negative. Today, the average interest rate on savings accounts in the United States is 0.05%, while 10-year inflation expectations are 1.9%. This produces a negative real return of -1.85%.⁴ We see better opportunities in stocks and bonds.
A cautious approach to risk
The final quarter of 2020 has been one of the most risk-on environments we‘ve seen, with some of the best returns ever from small-cap stocks and cyclical sectors. We want to keep expectations in check here. Financial asset returns were exceptionally strong in 2020 given the challenging economic environment widely experienced during the pandemic. Investors should be careful not to overreach for risk, especially as positive sentiment builds and cash goes to work. We believe a balanced portfolio of global equities and fixed income, with a mix of high-conviction ideas within each bucket, remains the best approach for a risk-managed portfolio with upside potential.