Mullaney on the Markets

Stimulus, Taxes and COVID in Focus in 2021

The S&P 500 closed the year at another record high; investors, however, likely won’t be able to count on multiple expansion to drive performance over the next 12 months.

By Michael Mullaney | Director of Global Markets Research

Published January 2020

The U.S. stock market ended 2020 on a strong note with the S&P 500 advancing for a sixth consecutive month in December. The index gained +3.84% on the month to reach a new record high of 3756.07 – its 33rd record high of the year. Investors chose to look past a new wave of coronavirus cases and state-led activity restrictions by focusing on the vaccine rollout and a new $908 billion stimulus package passed by Congress.

After experiencing a 34% drawdown during the first quarter of the year, the index has risen nearly 69% off its March 23rd low, up by +12.15% during the 4th quarter and +18.40% for the year, thanks to massive monetary and fiscal stimulus, vaccine optimism and the corresponding “V” shaped recovery of many economic variables. The path to the gains was far from “smooth sailing.” The number of days throughout the year with price swings in excess of 1% (in either direction) and the overall level of volatility (>30%) were second only to the Global Financial Crisis of 2008. All eleven sectors comprising the S&P 500 showed gains during the month, lead by Financials, which returned +6.28% as inflation expectations increased, rates rose, and the yield curve steepened.

The Federal Reserve also gave the “okay” for banks to resume share buybacks and increase dividend payments to shareholders. Meanwhile, after falling for two consecutive months on profit taking and fears of government antitrust intervention, Technology followed with a gain of +5.74% during December as Q3 earnings for the sector grew by 6.4% versus a consensus estimate projecting a loss of -6.12% entering the period. Pulling up the rear was the Utilities sector, which struggled to post a positive return in December, gaining just +0.70% with pressure from the increase in interest rates.

For the quarter, Energy led all sectors, gaining +27.77% as the price of a barrel of WTI oil jumped +20.64% and Brent crude by +24.93% over the period. Financials were a close second at +23.22%, though year-to-date Technology led all sectors with a gain of +43.89%. Weakness in another bond-proxy group was evident during the quarter, as Real Estate returned “just” +4.94% but dropped by -2.17% for the year. Energy failed to overcome an earlier COVID-induced demand shock with the sector falling by -33.68% for the year.

Risk-On Mentality Continues

With their U.S.-centric business models and large exposure to service-based industries with high operating leverage, small capitalization stocks continued their strong performance in December with the Russell 2000 Index posting a return of +8.65%. This contributed to the gain of +31.37% for the quarter, the best on record for the index. The strong gain for the quarter also pushed the Russell 2000 into positive territory for the year with a gain of +19.96%. Large capitalization stocks, as measured by the Russell 1000 Index, lagged small-caps over the near term, returning +4.22% for the month and +13.69% for the quarter. However, superior returns from earlier in the year helped large-caps maintain a year-to-date lead over small-caps for the year with a gain of +20.95%.
During December, other examples of the recent “risk-on” trading mentality continued. Stocks within the S&P 1500 Index rated “B” or lower by Standard & Poor’s outpaced those ranked “B+” or higher by over 3%.

Meanwhile, the highest beta quintile of stocks in the S&P 500 beat the lowest beta quintile by 5%. For the year, low-quality stocks beat high-quality stocks by over 11% in the S&P 1500 Index and high beta beat low beta by nearly 15% in the S&P 500.

The broadening of returns also continued with the equal-weighted version of the S&P 500 beating the capitalization-weighted benchmark by 30 basis points during December and by nearly 6.5% for the quarter. For the year, the cap-weighted S&P maintained its outperformance relative to the equal-weighted version. This was due to the earlier strength of returns among the top five largest stocks in the index.

In December, Value lagged Growth by an average of 79 basis points across the Russell 1000, Mid-cap and 2000 style benchmarks. For the quarter, Value beat Growth by +3.34% across the three capitalization segments, representing the best quarterly performance for Value since December 2016. Growth outperformed for the year.

In the international arena it was a clean sweep for the MSCI EM Index as the benchmark beat the S&P 500 on a one-month, three-month and year-to-date basis, in both local and U.S. Dollar currency terms. This is the first time that has happened since 2017. The return for emerging market stocks was particularly strong in the second half of the year with EM beating the S&P by over 11% on average over that period with tailwinds from vaccine optimism, the cyclical recovery and a weaker U.S. dollar. The +19.77% return posted by the EM index for the quarter in dollars was the highest since June 2009.

The returns of developed market stocks did not keep pace with those in emerging markets. The MSCI EAFE Index lagged the S&P 500 over a one-month, three-month and year-to-date basis in local currency terms. However, a drop of nearly 5% during the last three months of the year for the broad trade-weighted dollar led to a +4.67% return for EAFE in December and +16.09% for the quarter in $USD terms.

2021 Outlook

After the debacle that occurred at our nation’s capital — something that none of us thought would or could happen in our lifetime – representatives of Congress were able to complete the certification of the Electoral College results and name Joe Biden and Kamala Harris as President and Vice President of the United States. Almost simultaneously, the people of Georgia elected two Democratic candidates to the Senate in the state’s run-off election, giving the Democratic party control the White House, the House of Representatives and the Senate.

It is expected that the newly unified Democratic government will undertake two major legislative initiatives. First, focus will likely revolve around a new massive stimulus bill encompassing infrastructure, clean energy and expanded health care services. Second, market-watchers are anticipating a comprehensive tax bill to help pay for the stimulus, likely affecting corporations, individuals and estates.

Taken together, the anticipated proposals could have significant ramifications for the economy and the stock market. The Biden stimulus package could add as much as 1.5% to GDP in 2021 in what is already expected to be one of the strongest years in recent history. A 2022 increase in corporate taxes could reduce earnings for that year by as much as 15%. Collectively, investors are labeling the likely legislation as a “gain now/pain later” proposition. Since 1950, a U.S. government comprised of a Democratic President and a unified Democratic Congress has produced an annualized return of +13.2% for the S&P 500, very respectable but slightly lower than the +15.9% return attained under a Democratic President and split Congress. As mentioned last month, markets like “checks and balances.”

While a moderate increase in inflation is expected in 2021, there are indications that there could be an upside surprise to the consensus estimate. This could test the resolve of the Federal Reserve and their pledge to keep rates lower for longer. Any meaningful increase in interest rates would place pressure on valuation multiples, particularly on longer-duration Growth stocks. If the Fed’s ongoing QE program continues to suppress nominal bond yields, then one should expect the recent dollar weakness to continue, a byproduct of a negative real yield environment. As compared to 2020, earnings will need to grow into elevated price/earning multiples in 2021 – said another way, investors should not expect another year in which multiple expansion is the driver of stock prices.

The biggest tail-risk to the economy and the markets continues to be COVID-related. Any difficulties in distributing or administering the vaccine on a global basis will only prolong an unacceptably high rate of transmission of the virus, which would continue to prolong lockdowns and restrictions amongst countries, states and counties, and call into question the likelihood of the “V” shaped recovery continuing.

Boston Partners Global Investors, Inc. (“Boston Partners”) is an investment adviser registered with the SEC under the Investment Advisers Act of 1940. Registration does not imply a certain level of skill or training. The views expressed in this commentary reflect those of the author as of the date of this commentary. Any such views are subject to change at any time based on market and other conditions and Boston Partners disclaims any responsibility to update such views. Past performance is not an indication of future results. Discussions of securities, market returns and trends are not intended to be a forecast of future events or returns.

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