The US economy has slowed down its recovery lately and will probably be weaker early 2021. While GDP growth slowed in the fourth quarter to a range of 3-5%, it could continue slowing down to a 1%-3% range in the first quarter of 2021. Assuming a second COVID- 19 relief package will pass the Congress despite the recent set back with the current White House administration. One has to be cautious as the impact of the virus on the economy is hard to assess and forecast. Recently we saw an uptick in infections, hospitalizations, and deaths reported. Because of fresh restrictions and local lockdowns, we also witnessed an increase in weekly jobless filings, as well as business closures (especially restaurants).
However, mass distribution of COVID- 19 vaccines by spring likely to bring a drop in infections and deaths. On top of that consumers have beefed up savings in 2020 despite difficult economic conditions. The pent-up demand is there, and business output is to respond to satisfy what could be a very healthy consumption in 2021.
Congress passed a COVID relief package worth roughly $900bn (4% of GDP). This combined with the Fed commitment to long-run monetary support will be helpful as well.
While the global economy grew in October much faster than what consensus expected, the current quarter witnesses a significant downshift to a 3.1% growth rate according to JP Morgan. COVID-19 drags hit consumer spending readings in the most affected countries last month as US and UK retail sales and DM auto sales posted significant declines. Virus containment measures also are being increased or extended. On the surface, the news appears at odds with an impressive appreciation in global asset and commodity prices in December 2020. However, the markets are both looking through the near-term soft patch. The early rollout of effective vaccines bolsters confidence that the COVID-19 second wave will be short-lived and that mass vaccinations set the stage for a sustained recovery in economic activity starting in the second quarter of 2021. With Brexit finally over and an agreement between Great Britain and Europe in place, we expect reduced uncertainty in the marketplace – a welcome development.
So, even with a first quarter drag, JP Morgan still looks for global GDP to boom 4.8% next year, the fastest gain in over two decades. The promise of robust global growth is kindling reflation hopes. JP Morgan believes though that subdued inflation in services will prevent strong inflation. Jeremy Siegel of Wharton Business School believes that inflation could rise a bit higher. Again, we are talking about inflation above a long-term Fed target of 2% (maybe 3-4% a year) but not hyper-inflation. Such a development could further boost stocks in general. Additionally, higher long-term interest rates could benefit the Value camp in particular.
Stock Market and Factor Investing
In 2020 from January through September Large Cap Growth cohort and Growth factor (see Factor Performance Heatmap below) in general strongly dominated the market. However, starting in October we saw a preference to Value. In November Value had a very strong showing but the other important fundamental factors turned sharply negative. Usually for a multi factor approach to work, one would like to see several categories working simultaneously. In our Large Cap actively managed portfolios, Value’s strong showing helped lately. We have a barbell structure in portfolios with exposure to and great Growth stocks in Technology, Communications and Consumers, while also invested in deep value stocks in Financials, Industrials, Energy and other sectors.
Factor Performance (Top 2 quintiles of Large Cap Universe vs. SP 500) (Source – Signet FM):
Small Caps reflected Large Cap peers with regards to Growth dominating strongly as well for three quarters of 2020. However, the recent Value flight was so strong among Small Caps that other important fundamental factors got hurt with what we call a garbage flight. This is when fundamentally weak stocks strongly depressed by drawdown in the market due to a recession start flying on news that things are starting to improve. So, while Value alone has had a huge run, holistically fundamental strong stocks are left behind for a very brief moment. We saw this phenomenon in the aftermath of Great Recession, and we see it today. Those periods are usually short-lived and small caps, and we believe that holistically strong fundamental characteristics (including Value, Profitability, Yield, Safety, Growth) and not just Value, should take the lead in the long run. That being said, we are still confident that exposure to Small caps through active or passive strategies makes sense coming out of recession since you are getting in at a very opportune moment.
As we go to print Valuation spreads are still high versus historic norms (See VS chart below), so we see more upside to Value strategies well into 2021. We believe Mid-Caps are particularly attractive at the moment. Large Cap Growth stocks have been dominating for the last few years.
Large vs. Small and Growth vs. Value 2020 YTD (as of 12/23/2020) (Source – Signet FM):
Valuation Spreads (Source – Signet FM): through November 2020
The broad market started coming back in strides over the last couple months – a mean reversion we have discussed for a long time starts happening! Concentration in the marketplace is still elevated though (see Equal vs. Market Cap Weighted chart below) and it will take a more meaningful mean reversion to erase mispricing based even on Price to Sales ratio – the least biased of all Value factors. We still see promising Value across all sectors. The economy has been recovering in the second half of 2020 and while it could pause early in 2021 due to restrictions because of the virus, the vaccination of population and more stimulus should support the markets going forward!
Equal vs. Market Weighted 1 Yr. Return Spread (Source – Signet FM): through November 2020
The information and opinions included in this document are for background purposes only, are not intended to be full or complete, and should not be viewed as an indication of future results. The information sources used in this letter are: WSJ.com, Jeremy Siegel, PhD (Jeremysiegel.com), Goldman Sachs, JP Morgan, Empirical Research Partners, Value Line, Ned Davis Research, First Trust, Citi research and Nuveen.