Taking stock: 11 themes to consider as we look toward 2021

Rick Rieder and team highlight 11 themes investors can draw on to successfully guide portfolios into 2021.

As we’ve mentioned in past years, the approaching transition of the calendar year invites both reflection over the prior twelve months and the temptation to prognosticate regarding the course of the year ahead. While this has long been a fascination particularly popular in the financial world, we are especially struck this year by how unanticipated many of the defining events of 2020 (and chiefly the Covid pandemic) were from the vantage point of the year’s beginning. Still, in our view, many of the most critical investment themes are often secular in nature, and even cyclical drivers can adhere to forces that are quite agnostic to our traditional calendar.

So, with all that in mind, as unpredictable as 2020 was, one prediction we feel quite comfortable making about the future is that investors will need to meet their return targets, if they are to achieve their financial goals. Yet the investment landscape has never been this tumultuous, barring the Great Depression, with geopolitical, social, economic and public health uncertainties all continuing to loom large. Today, we explain how we are taking stock (more of it) of where we are, while highlighting 11 themes we think investors can draw on to successfully guide portfolios through the rest of this year and into 2021.

1) In 2021, GDP growth will surprise the skeptics

Despite the rising risks to the economy from a second wave of Covid spread in late-2020, we think the path to a stronger than expected NGDP outcome for 2021 lies in three potent sources of fuel. First, some combination of new fiscal stimulus to combat Covid’s threat to the economy (although probably less than what was being negotiated pre-election), and a structural budget deficit, is likely to place more than 5% of GDP in the form of public sector outlays into private sector coffers. Second, the Federal Reserve’s ongoing asset purchases amount to a direct monetization of this private sector windfall. Third, we entered the post-election period with impressive economic momentum that is still broadly underestimated, and we think a post-election and post-pandemic (by early-2021, successful vaccine candidates will likely be ready for more widespread use) world can catalyze 2020’s monetized stimulus (more than 15% of GDP) into impressive NGDP growth (see Figure 1).

Figure 1: U.S. NGDP May be on Track for Higher Than Expected Growth

The macroeconomic “Equation of Exchange” suggests that the money supply and velocity of that money directly correlate to the prices and quantities that make up nominal GDP (M*V=P*Q). The massive pandemic stimulus that was monetized by the Fed this year is permanent stimulus, since the Fed has explicitly stated that it will not proactively reduce its balance sheet going forward, so as not to risk jeopardizing the recovery. That marriage of monetary and fiscal policy is a large-scale injection of ‘M’ that will continue to catalyze accelerating growth in the future, as real economy velocity resumes.

2) The economy is flush with cash, supporting consumption potential

For all sectors of the economy, the common reflex during times of financial or economic stress is to build cash reserves, but what happens after all that cash is raised? Households now have cash to spend, or to see them through any near-term economic weakness. Today, personal savings are $1.3 trillion higher than they otherwise would have been following the pre-pandemic trend, which is equivalent to more than 6% of GDP. As mentioned, this can act either as an effective shock absorber for sticky joblessness (though recent payroll data continues to be encouraging), or it can potentially be a powerful stash of pent up resources for consumption. The latter possibility may already be evident in the data, with retail sales roaring back to new highs since April’s trough, and business inventories testing new lows in October, trends we think will continue to support growth. Further, it should be noted that the corporate sector too has built cash reserves, and even the Federal government is holding onto historically high levels of cash, with $1.7 trillion sitting in the U.S. Treasury’s General Account. All together, these resources should not only help bridge the gap to the next fiscal stimulus plan but may also provide further fuel to growth in the year to come.

3) The Soothsayers of Doom, who claim to see crisis around the corner as a result of a higher debt burden and a larger Fed balance sheet, will keep waiting

Pessimism can be a persistent sentiment, and occasionally it can be the right take on the economy for a period of time, but when it is constantly put forward by the same market commentators year after year, it is more often than not, unwarranted. The fact is that we think it’s much more likely that fiscal and monetary policy will win the day against the economic crisis brought on by the Coronavirus and its attendant impact on growth. Further, contrary to the fears expressed by many, the economic and financial system can handle the required incremental debt added to finance rescue measures and support the economy until a vaccine (or, likely a set of vaccines, as well as more effective therapeutics) firmly controls the Covid health crisis.

We think that smart, and targeted, fiscal policy that generates robust nominal GDP growth over time can organically mitigate the potential negative impacts of large single-year deficits, like we saw in 2020, perhaps even without raising taxes. As mentioned, the U.S. Treasury is sitting on a staggering $1.7 trillion of cash while the Congressional Budget Office estimates the combined fiscal 2020 and 2021 revenue shortfalls, relative to fiscal 2019, will be about $374 billion. Thus, a significant cash buffer already exists to offset the expected pandemic-related revenue shortfalls. Moreover, the burden of carrying incremental crisis-induced debt (the interest expense) will actually be shrinking in the coming years, according to the CBO, as the Fed neutralizes debt at historically low interest rate levels. At the same time, future nominal GDP growth should push the needle even further in favor of debt sustainability. The fact is that; historically speaking, U.S. budget imbalances can become insignificant over time, as compounded nominal GDP growth overwhelms them, and we believe this will be the case for 2020 and 2021 deficits too (see Figure 2).

Figure 2: It’s all about growth- U.S. budget imbalances can fade to insignificance over time

4) The USD should moderate lower and inflation move gently higher

There are some skeptics who have sounded alarm bells this year, with their calls for the U.S. dollar to collapse lower and for the rate of inflation to explode higher, largely due to the monetary and fiscal policy response, but again we think these portents of doom are misguided. Rather, we think it likely that the dollar should move moderately lower, as global risk appetite returns, and U.S. inflation should move gently higher from pandemic-period depressed levels. Indeed, while the momentum of the marginal U.S. policy rate move has been lower, when the dust settles, the policy differential will still favor the USD over other large trading partners’ currencies. Further, the data also suggests that inflation has a stronger relationship with demographic curves than with currency movements over the long term (see Figure 3), and in the U.S., the aging demographic profile and slowing rate of population growth imply that it may be much more difficult for the Fed to “create” 2% inflation in the future; already something the central bank has struggled with.

Figure 3: Demographic curves dominate currency movements for long-run inflation influence

Moreover, we think there are longstanding structural reasons for why those who have been warning of excessively higher levels of inflation will continue to be wrong in their prognostications. The fact is that over the past four decades the secular shift away from goods production/consumption and toward a greater economic focus on services has profoundly influenced virtually every aspect of economic life, from employment, wages, income, consumption, investment and price inflation. Indeed, goods-sector inflation has really been deflation over at least the past two decades. Over that time goods prices in the CPI report were down at an average year-over-year rate of -0.02% in the core goods index and were down -0.31% annually over the past five years. Additionally, oil prices used to be a primary driver of inflation and of inflation volatility, but new technology (fracking) has allowed supply to react almost instantaneously to demand and has altered the inflation volatility paradigm. These factors, alongside of the broadly disinflationary impact of productivity-enhancing technologies and the critical trend of population aging has combined to create a remarkable degree of price stability. To be sure, we are currently witnessing some of the lowest levels of inflation volatility in history.

And with the future of the demographic curve looking nearly like the mirror image of its own history (0% to 0.85% expected annual population growth from 2010 through 2150, versus the 1.8% average annual population growth from 1950-1999), we can expect the downward pressures on inflation to be with us for a very long time. Remarkably, the result of all this is that it is ‘price stability’ (not prices themselves) that has achieved unheard of levels. In the end, while we think that we’re likely to see modestly higher inflation by mid-2021, barring another lockdown-inspired economic slowing, the alarmist arguments for much higher rates of inflation as a result of current monetary and fiscal policies are ultimately unconvincing.

5) Some of those same Soothsayers of Doom claim we’re in another ‘2000 tech bubble,’ but again we would suggest otherwise

In our view, technological innovation is changing the world of productivity and potential growth like nothing we have ever seen before, and the critical difference between now and 20 years ago is that now it’s with real cash flows alongside it. So, while very strong early-stage growth is not unprecedented for newly formed corporations; we are seeing similar trends between today’s startups and the startup phases of today’s incumbents (for instance, think Shopify vs. Home Depot). Yet what differs today is the potential profitability of startups, and the historic speed with which they might attain it. The fact is that the asset-light model that many new tech companies run today has allowed for large scale free cash flow generation – there is much less need to invest the years of time and intensive capital in building out a global networks of stores when you can distribute your product via the smartphone already in your customer’s pocket. Instead of reinvesting profits into maintaining and growing capital assets, many of today’s tech startups can spend every incremental dollar expanding their reach along the existing (intangible) asset base. And while speculative investment fervor may get ahead of itself in some cases, the fundamental valuations of the tech sector as a whole are, for the most part, justified by the rapid and enormous free cash flow growth potential there.

6) We are living through one of the greatest commercial revolutions in history, and potentially the most exciting time for investing

Related to our last point, the ability for companies to create scale globally while generating real cash flow alongside of a massive available market opportunity makes this an extraordinarily exciting time to be an investor. Take as examples the fact that: Instagram grew its user base 10x in five years; TikTok did the same in less than three years. The direct-to-consumer digital platform Disney+ recently crossed 73 million subscribers within several months of its launch, rivaling the subscriber bases of established cable companies, and benefiting greatly in the pandemic environment. While some describe these phenomena as “fads,” we think they reveal a massive underlying evolution in both productivity and around the ability to build scale.

The virus has accelerated this evolution, but while some companies have recognized a window of opportunity to revamp stale business models, others have missed that window, while still others have failed to even notice the window. We look forward to carefully examining and investing in this ‘technology supercycle,’ as it plays out in the coming years, perhaps on a scale surpassing even the ‘commodity supercycle’ of the 2000s, as can be seen in the dramatically higher free cash flows there (see Figure 4).

Figure 4: The latest free-cash-flow dynamic in tech far exceeds that witnessed in the prior commodity cycle

7) Skeptics say that P/E ratios are too high, but it’s cash flow, duration and discount rates that really matter

We’ve long heard arguments that many skeptics make that contends P/E ratios are too high in U.S. equity markets, but in our estimation P/E ratios can be superficial in the sense that the measure does not consider changes to discount rates. Accounting for the discount rate leaves investors with the equity risk premium, the premium the market is awarding to the equity segment of the capital structure over risk free assets.

And today’s equity risk premium is near the wider end of its 50-year range (which was not the case in 2000), as can be seen in Figure 5 (Top). Further, the free cash flow yield on the S&P 500 is a whopping 10x the yield available on the 2-Year U.S. Treasury note, based on what the market expects it to yield 2 years from now (Figure 5, Bottom). In the 2000s, this 2Y2Y forward traded above the S&P 500 free cash flow yield. Thus, with elevated growth and low discount rates, the time value of money suggests that only a small fraction of equity value is derived from the near future, or in other words, the pandemic-hit earnings; rather, it’s all about future cash flows, in a further out future that will surely benefit more from today’s productivity enhancements, and is very likely to be an environment in which the virus is under firm control.

Figure 5: Elevated equity risk premia and SPX FCF Yield vs. 2Y2Y changes the case for equities

8) For now, asset allocation will be most influenced by where you take “duration risk” in financial assets, and that shouldn’t be in the highest quality bonds

By our accounting, investor’s total return potential can be generated in three ways: 1) risk-premium compression (spread compression or yield compression), 2) compounding growth of cash flows, or 3) meaningful duration. Yet, investors rarely talk about the long duration of stocks the way they do of bonds, which is something we think can be instructive. The duration of high-quality U.S. fixed income markets has increased by north of 50% over the last two decades, from less than 5 years modified-adjusted duration to more than 7 years in U.S. Treasuries, and from less than 6 years to almost 9 years duration in corporate sector bonds.

Still, the Treasury and U.S. corporations have benefitted from record low yield levels at the back end of the curve, by locking in very low borrowing costs (effectively, negative real yields), which has injected substantial duration risk into the market. But duration works both ways: if you don’t have a risk premium to compress, duration can be a dangerous risk rather than a useful tool in portfolio construction, and it is becoming increasingly important to assess how to implement it effectively. Indeed, duration risk at a negative real yield guarantees a real loss at the maturity of such an asset.

9) Volatility is an often-mentioned concept in the financial media, and one of the least often utilized, but potentially it’s the most useful tool for asset allocation, income creation, and portfolio durability

By some measures, the volatility experienced by the market in March/April was greater even than that witnessed at the height of the Great Depression. Today, even though the S&P 500 has closed the entirety of its drawdown, the price of portfolio insurance remains above average – a unique phenomenon in recent years, and one that has resolved itself in the past with the price of that insurance declining (see Figure 6).

Figure 6: Yields available from selling elevated volatility remain above average

With yields in fixed income markets at historically low levels, the above-average yield available in volatility strategies stands out (as do above-average equity-linked yields). A representative sample of seven blue chip industrials now have dividend yields exceeding their long (30 year) bond yields, while overwriting these companies through a covered call strategy would generate a total yield of almost 4x their average long bond yield (see Figure 6). Astute investors would do well to protect portfolios when the market expects volatility to be excessively low, and lock in yield enhancements when the price of that volatility is more reflective of the generational shocks of the past than the realities of the future.

10) Go outside the U.S. to buy some bonds, but inside to buy some stock (and don’t forget Asia here too)

The net supply of U.S. Treasuries is expected to grow next year, while the net supply in Europe will likely still be negative in the fourth quarter of 2020 and in 2021. This technical exemplifies part of the argument to replace U.S. bonds with non-U.S. bonds (while at the same time maintaining a U.S. overweight in equities). Asia and other emerging markets, on the other hand, stand out possibly on both fronts – their bonds have sizeable risk premiums to U.S. Treasuries for potential spread compression, while their equities benefit from many of the same tailwinds that those here in the U.S. enjoy. EM (especially Asia) has proven surprisingly resilient during the Covid crisis and could do especially well in a world of: 1) ample USD liquidity; 2) rebounding global growth; 3) a weaker USD and 4) compressing yield/risk premiums.

11) There’s tremendous yield scarcity in the world today, relative to the massive demand for it – get sufficient yield (3% to 5%) but don’t stretch too far, or own too much of “value-free” fixed Income

One would be hard pressed to find a portfolio of high-quality fixed income that meets a 4% yield target. Dipping into securitized assets, high yield, and emerging markets has become imperative. At the same time, holding some cash instead of high-quality fixed income is not that punitive since the yield give-up is relatively low, and the reduced duration risk could be beneficial. Employing this kind of barbell approach by combining “yieldier” assets with some cash can actually increase portfolio yield and lower overall portfolio volatility. To use U.S. credit as an example, when high yield bonds yield 3x that of investment-grade bonds, but aren’t 3x as volatile, a 50-50 cash-HY barbell portfolio out-yields an IG portfolio, with a lower historical volatility and a better risk-adjusted yield. Adding yielding assets is the key to maintaining both stability and the chance at a potential 4% return in bonds and possible 7% total return on a well-constructed portfolio.

So, having taken stock of where we are, investors would be right to conclude that they should take (own) more stock coming out of the Covid-19 pandemic. We think the table is set for a durable risk rally that will be characterized by deteriorating realized volatility, with some modest curve steepening, especially in the U.S. We also see an ongoing deficit of yielding assets that would allow investors to potentially achieve a 3%-5% yield, combined with a benign fundamental backdrop that could lead to a grind tighter for most U.S. spread assets. At the same time, a weaker dollar (or a USD that doesn’t strengthen from here) can catalyze emerging markets and allow the asset class to finally participate in a rally with some true momentum.