A year ago, if I told you that 2020 would have an environment including a global pandemic, a global forced shutdown of non-essential business, a giant spike in unemployment, social unrest and a contested U.S. presidential election, how would you have thought the stock market would perform?
Would you discount a scenario where the S&P 500 index was positive, let alone up 18.4 percent including dividends? Furthermore, would you forecast that Emerging Markets stocks, typically seen as riskier investments, would outperform the S&P 500?
2020 will go down in history as a year of unprecedented events for our country and our world. Another massive disconnect between Wall Street and Main Street continues to grow, despite entering 2021 with the events we witnessed in Washington, D.C., as well as COVID-19 pandemic levels at their height. Reflecting on 2020 and looking forward to 2021 and beyond, here are some important insights that may help shape the investment landscape going forward.
A Reflection on 2020
The most important element not included above was the massive fiscal and monetary response to COVID-19. As the pandemic reached the developed world in February and March, the global economy all but shut down. Global stocks plummeted almost every day from February 19 to March 22, eventually resulting in a 34 percent peak-to-trough decline in the S&P 500 Index, a proxy for the U.S. stock market.
But the unprecedented events eventually led to unprecedented economic stimulus, with the Federal Reserve cutting interest rates to zero on March 15, more quantitative easing, the announcement of several central bank stimulus programs and the $2.2 trillion CARES Act announced by Congress later that month. Markets responded dramatically to the economic stimulus, rallying from the lows on March 22 to closing at or near record highs for the year.
While the situation seemed dire at the moment, the battle between a pandemic-induced economic coma and unprecedented levels of economic stimulus raged throughout the year. By year-end, economic stimulus won the battle. This reflection is important in remembering the age-old adage: Don’t fight the Fed (as long as it remains in control of the situation).
However, this is another important reminder that short-term market forecasting is a fool’s errand.
As your institutional investment manager, we do not attempt to forecast markets over short periods of time. In fact, the Investment Committee at The San Diego Foundation believes that one of the biggest advantages an investor can have is time. Time allows an investor to weather volatility, ride through the highs and the lows, and benefit from the long-term upward trajectory of asset prices.
The other significant advantage to investing comes in discipline. If you have time on your side, you must also have the discipline to execute your investment approach, remove emotion from the equation, and rebalance into risky areas when the world might seem like it is coming to an end. Another important reminder of the age-old adage: buy low and sell high.
Looking Ahead
With the U.S. stock market sitting near all-time highs in early 2021, there is indeed some light at the end of the tunnel.
The development of several successful vaccines for COVID-19 were announced at the end of 2020. Despite the events in Washington, D.C. at the beginning of 2021, there is now clarity in our presidential leadership. It certainly feels like the stock market is optimistic about our economic future with the massive rally experienced over the last two months, but more and more market pundits are surprised about the disconnect between Wall Street and Main Street.
As I reflect on the future, there are two key topics that all investors should consider:
1. Can the Federal Reserve continue to guide us through this unprecedented environment with extreme monetary stimulus measures?
Markets have been dependent on low rates and quantitative easing for much of the last decade. In 2020, the Federal Reserve announced an important change to its dual mandate of maximum employment and price stability. Instead of targeting a 2 percent inflation rate, the Fed announced its new target is an average inflation rate of 2 percent, with a likely aim to achieve inflation moderately above 2 percent for some time.
While many investors including the Fed were worried about deflationary forces in the near-term, will the Federal Reserve be able to keep inflation in check should they allow it to exceed 2 percent? That will likely be a significant question going forward, and one that many are already concerned about. A decline in the value of the U.S. dollar, a dramatic rebound in commodity prices and an increase in TIPs (Treasury Inflation-Protected Securities) break-even spreads are all supportive of possible inflationary forces going forward.
2. Are we entering a new environment where long-term investment returns across all asset classes will be lower?
The process of conducting an asset allocation study requires long-term forecasting. The long-term forecast for stocks is generally based off the risk-free rate and the starting value of the stock market. With the U.S. stock market hovering at all-time highs and the risk-free rate near all-time lows, it is difficult to forecast an average return for the U.S. stock market over the next 10 years. That said, we know lower interest rate environments can lead to sustained elevated valuation levels for stocks.
With interest rates as low as they are today, forecasting an average long-term return for bonds is even more difficult. Interest rates have limited downside if the Federal Reserve wishes not to invoke a negative interest rate policy. This significantly limits the upside for fixed income, and furthermore, results in the possibility of less protection from bonds in a “flight-to-quality” environment.
Ultimately, investors may be forced to accept a lower overall rate of return or take on significantly greater risk in their portfolios to achieve the same rate of return they are used to receiving. This trade-off is one that The San Diego Investment Committee will study at length in coming months.
Steps Forward
As we invest your charitable dollars at The San Diego Foundation, we take a long-term, disciplined approach to investing. We do not make short-term forecasts, and therefore do not attempt to time the market. If nothing else, 2020 illustrates that the approach we take to investing works.
Going forward, we will examine some of the looming questions described above and make the appropriate adjustments to each portfolio. We will also seek to identify undervalued investment opportunities born out of 2020 and allocate capital appropriately in a long-term, disciplined, and diversified fashion. Meanwhile, as a San Diego-based nonprofit enabling community solutions, we will continue our work in the community to address inequities and help those on Main Street that are suffering due to the ongoing pandemic and ramifications associated with it.
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