Island Light Quarterly Commentary (Jan 2021)
“Hope is being able to see that there is light despite all of the darkness.” ― Desmond Tutu
In the midst of the worst pandemic in a hundred years, when there was no vaccine in sight, when policy decisions were mixed at best and cable news kept an up-to-the minute count of the sick and dead, the human spirit was not shattered. When black men died at the hands of the police and marches for peace turned into rioting, when fires burned out of control while destroying villages and homes and cable news broadcast videos of murder and mayhem, we gave thanks. And when the churches and restaurants closed and the hospitals overflowed, the planes flew empty and borders were closed, when we shrank into small and lonely bubbles, we witnessed simple acts of grace. Where there was darkness, we found light. We hope for better. And in our hopefulness, we may also find reward.
On first blush, the year just ended was a bleak moment in history. The already lonely became lonelier by necessity. Many of the truly poor remained truly poor or their situation worsened. Men and women who were previously too proud to accept a stranger’s charity waited in food lines because they had no choice. Careers and business ended, never to restart or rebound. Many lost loved ones and friends. And yet, perhaps unexpectedly, many prospered as we embraced new technologies and ways of doing business. It was not all bad news. Location, career choice, health and economic status defined whether you gained or declined in 2020. Our hope for 2021 is that those who gained in 2020 will be gracious and do what they can to lift up those who declined, often through no fault of their own.
Markets looked past the short-term impact of the pandemic and focused on next year’s results. Recognized economic winners (tech stocks, online retailers, content providers) performed massively well. Recognized economic losers (energy, travel and lodging, corporate REITs) got hammered. Fiscal and monetary stimulus measures largely offset the impact of global shutdowns and large corporations held their own or exceeded expectations. As a result, the technology sector, up 43.6%, led the S&P 500 to another record close at the end of the year, with the market up 12.2% for the quarter and 18.4% for the year. Value stocks were positive for the year, up 2.5%, but growth stocks were up 36.7% as measured by the Russell 1000 Value and Growth indexes. Small stocks (Russell 2000) came roaring back in the fourth quarter, up more than 30% and finished the year up nearly 19%. 2020 was also a record year for IPOs and home sales.
This outstanding and unexpected stock market performance followed 2019 returns of 31.5%. In fact, the stock market has more than doubled in value in a little less than five years, which is remarkable considering the good performance of the early 2010s. For all the headline news, the world remains swollen with liquidity, government excess spending and expansive monetary policy. Add a rosy outlook for economic growth in 2021 when pent-up consumer demand will be released, and you get investor optimism and current record highs.
US Volatility as measured by the CBOE’s S&P 500 Volatility Index (“VIX”) ended the year at 22.8, continuing to settle into the 20-30 point range for the last half of the year, down from 53.5 on March 31 and up from 13.8 at this time last year. Any value above 20 is considered to be higher than “normal”. You may remember that the S&P 500 ended the day at a record high on February 20, dropped (-34%) by March 23, yet closed the year at another record high, up 68% from the March 23 low. We do not expect this kind of volatility in 2021 unless another major exogenous shock flips markets.
Global equities, as measured by the MSCI ACWI index, returned 14.7% for the quarter and 16.3% for the year. International markets were boosted by a weakening dollar (off 4.2% for the quarter and 6.7% for the year) with emerging markets (MSCI EM) returning 19.7% in the fourth quarter and 18.3% for the year while developed markets (MSCI EAFE + CA) returned 15.9% for the quarter and 7.6% for the year. As in the US, ex-US growth outperformed ex-US value by 23%. The Nordic and Emerging Asia regions had strong positive returns while South America and Eastern Europe significantly underperformed. (MSCI)
Every major fixed income asset class was positive for the year ended December 31, after a rollicking fourth quarter for the riskiest of bonds. US Bonds, as measured by the Bloomberg Barclays US Aggregate Bond Index, were modestly positive, returning 0.7% for the quarter and 7.5% for the year ended December 31. Inflation protected bonds outperformed the aggregate bond index, returning 11.0% for the year. The highest returning fixed income classes in 2020 were long dated US Treasuries, up 16.7% for the year (IA/SBBI Long Govt Index), the lowest from short-term Treasury bonds returning around 1.0% for the year.
US Interest rates, as measured by the benchmark 10-year Treasury yield, ended the quarter at 0.92%, trending upward since a March low of 0.54% but still below the 1.92% rate at this time last year. With implied 10-year inflation at 1.99% on December 31 (the highest level recorded since the summer of 2018, as measured by the breakeven inflation rate between inflation protected securities and treasury bonds), real yields in the US remain negative and nominal rates continue to trend at the lowest range in 60 years. But if you think that US rates are low, consider the rest of the world. The German 10-year Bund yield is (-0.58%) at year end, the UK 10-year gilt yield is 0.19% and the Japanese 10-year bond rate is 0.01%. These overseas borrowing rates will limit the ability of US rates to rise even if the Federal Reserve feels like increasing rates, which they have shown no sign of wanting to do. Unless there is significant upward pressure due to massive federal debt holdings or more rapid economic growth globally, we do not anticipate that there will be a large increase in government bond rates in 2021.
With government bond yields at such lows, the search for yield from any source will continue to be a theme in 2021 and will likely continue to drive investors toward riskier assets such as stocks. Further weakening of the US dollar may well make foreign assets, gold and other commodities attractive. We anticipate continued inflows into these asset classes.
Even as low mortgage rates contributed to year-over-year growth of nearly 6% in the housing sector, the market for existing home sales showed signs of losing momentum. Pending home sales fell for a third consecutive month in November. We expect that depleted inventories and higher prices (up 8.4% nationally) will offset strong demand and low rates to present headwinds to housing sales in 2021.
US consumer confidence dropped at the end of the December, nearly back to the low levels seen in April and May at the height of the first wave of COVID and lowing momentum gained over the summer. But business confidence, according to the Measure of CEO Confidence, was up sharply at the beginning of the fourth quarter to 64 from 45 in the previous. Note that a measure above 50 points reflects more positive than negative responses. (Conference Board). This confidence may also be reflected in US earnings expectations; estimates for 2021 have been rising since July to up 21.9% in December (Zacks) albeit from a lousy 2020.
Unacceptably high unemployment remains a drag on economic performance. According to Oxford economics, jobless claims remain firmly above 1,000,000, down from the early days of the pandemic but still an historically high reading. While prospects for the economy later in 2021 are upbeat (estimates are for 3.8% growth in 2021 which may well be low), the economy and labor market will have to navigate some difficult terrain between now and then and we expect claims to remain elevated, with a corresponding drag on consumer confidence and spending.
Looking forward, we have hope for the future. The Covid-19 vaccines are now released and should be available to the public by the end of the first quarter. While economic slowdown will likely affect the economy through the end of June, we think that the last half of 2021 will be strong as the world returns to a new normal. Obviously, policy matters, and we do not know what a new administration will bring after another round of fiscal stimulus early in the year. Increases in income and corporate taxes seem inevitable and will be a drag on growth. Regulatory excess may also bring friction to earnings. But pent-up demand should overcome policy-related constraints and, with luck, a drop in unemployment will spur further consumer spending.
From an allocation point of view, longer duration bonds look relatively unattractive except as a hedge against equity losses. Despite very tight credit spreads, corporate bonds are the only way to find positive real yield in today’s environment and thus we are likely to remain short duration, long credit albeit with a lower overall bond exposure, offset by dividend-paying lower beta equities. On a fundamental basis, US equities look expensive relative to their ex-US counterparts. Growth stocks look expensive relative to value stocks. But to be honest, this has the been the case for more than five years now. Despite the last two quarters, it is still too early to declare that we are on the cusp of a sustained outperformance of value, small, and international stocks. However we may pursue selective increased exposure to these classes as the year goes on.
With the health crisis still very much part of our lives, it is too soon to say that stock market volatility is behind us. We try to stay away from over-reacting to short term events, but we will look for opportunities to take advantage of volatility, buying when markets are down and selling when markets are up, maintaining our target allocations with perhaps a slight overweight to equities. Over the last few years, we have been well served by maintaining a diversified set of assets in our portfolios, rebalancing infrequently while maintaining small thematic exposures to long term attractive assets. We expect to continue this approach in 2021.
We have great hope for the future and are happy to put 2020 in our rearview mirror. If 2021 can be a healthier, happier year, then we will all be blessed. We look forward to seeing you all in person later this year. And finally, in this time of rebirth and hope, may you all find joy, love and happiness, each and every day.
January 3, 2021