CIO 2021 MARKET OUTLOOK

As we consider stocks, and look at market multiples, we believe investors need to recognize that for these valuations to hold or improve, we need earnings to increase or there is a greater likelihood that stock prices correct to bring valuations back into line. Given the pent up demand from economic lock downs and the amount of excess savings that have been built up, we are looking at the four quarter period from the start of Q3 2021 to the end of Q2 2022 that could be a period of very strong economic growth as the economy opens more broadly, travel begins to resume and consumers begin to spend. Again, this is predicated on the success of the vaccine and/or herd immunity.

A word about stock prices and valuation. I am always reminded by the famous economist John Maynard Keyes’ saying, “the markets can remain irrational a lot longer than you can remain solvent.” In my view, the increased focus on passive management has naïve dollars flowing into the very largest names causing them to become even higher priced and thus causing their P/E ratios to become even more stretched. This is a market trend we will need to continue to watch as we move through 2021 and beyond.

Shifting to bonds, we start with a look at inflation. We came into 2020 with CPI running at 2.5% on an annualized basis when the index was released in January 2020. The last report detailed inflation through November and the CPI stood at 1.2% and was 1.6% when you factor out food and energy. Much of the stimulus and fiscal moves have been designed to avoid deflation. Regular readers of my monthly Market Insights column will recall several discussions on the need to avoid deflation because of how difficult deflation is to reverse. Nevertheless, we are indeed in a low inflation environment and to keep rates low to encourage borrowing, the Fed has persisted with the bond buying program. Because not all investors are ebullient about the stock market, we continue to see strong demand in the bond market.

The following table uses the option-adjusted spread (OAS) as the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to consider an embedded option. Typically, an analyst uses Treasury yields for the risk-free rate. The spread is added to the fixed-income security price to make the risk-free bond price the same as the bond. In simple English, the option adjusted spread is the extra yield earned by investors for holding these various corporate bonds versus a corresponding Treasury.

What you will see in the attached table is that we saw yield spreads hit 300 to 500 basis points over Treasuries during COVID-19 when looking at A to BAA issues of a variety of maturities. During the 2008/2009 Financial Crisis, these rates were even wider running 400 to 600 basis points over comparable Treasuries. Spreads widen when investors demand more yield because of a perceived level of risk. Yield spreads can also widen on a technical or supply/demand basis.

During COVID-19, while the stock market grabbed a lot of the headlines, bonds performed well because yield spreads came in dramatically. This spread movement was driven by the demand of investors to hold bonds both for income as well as to diversify and hedge some of their equity bets and bonds are now fairly expensive when one considers the paltrier yield spreads currently available.

Source: Bloomberg Barclays – US Intermediate Credit ‘A’ (~5yrs), US Credit ‘A’ (~10yrs), US Long Credit ‘A’ (~23yrs), US Intermediate Credit ‘Baa’ (~5yrs), US Credit ‘Baa’ (~10yrs) and US Long Credit ‘Baa’ (~23yrs)

When we look at the bond market performance of 2020, we look at the Bloomberg Barclays Aggregate Bond Index. This index returned 7.51% for the year, even though 10-year Treasuries had a yield range of 0.51% to 1.92% and averaged 0.90% for the year¹. The remainder of the strong performance for the index in our view can be attributed to the appreciating price of the bonds due to the narrowing of credit spreads.

This leads investors to question the value of holding fixed income. Many say that investors are flocking to stocks given the low rates in bonds and given the TINA principle (There Is No Alternative). We believe that even with low yields, bonds provide income and will serve to hedge equity volatility. Further, a careful review of shorter date, longer date and private credit opportunities may provide investors the ability to drive some income and to mitigate some of the volatility inherent in equity portfolios.

Finally, we will have a short discussion on international investing. Recently, as the dollar has been weaker, international stocks benefitted. We also continue to believe that the sheer number of international companies provide both a return and a diversification benefit when added to a portfolio of predominantly U.S. equities. The foreign markets have the same COVID-19 risk and the developed European markets, Japan and Australia may see faster vaccine roll out than some of the emerging markets. We do believe that the central tenet of the direction of COVID-19 is as valid for the foreign markets as it is for the U.S. market. We are, however, unwavering in our long-term view that prudently allocated portfolios should consider an allocation to non-dollar denominated investments.

Finally, let’s discuss some of the current trends in the economy. Will people flee the cities for the suburbs forever, will we work remotely in a greater way in the future? What does this mean for real estate? These are all questions I have heard from clients. At a high level, the attraction of suburban living may not abate quickly, but we think the published obituaries for cities like New York may be premature. However, cities are going to need to regain safety as an inducement to begin to bring people back. We too, believe that remote work will likely be in the mix going forward, but part of working together in the office is the comradery that is achieved when working with colleagues in person. I miss being able to be in our trading room to discuss market moving events or having impromptu discussions on a potential trade. I can speak of KoCAA, we are better together in person. We have made judicious use of Teams and conference calls, but I think the investment staff will be back in the office when it is safe, and we suppose other companies will follow suit.

Ultimately, we believe that like 9/11, after the initial shock subsides and, in this case, the risk of the virus wanes, we will begin to divine the true long-term trends. For now, we are watching commercial real estate and I believe it is fair to say, no one knows with any certainty exactly how the future for remote working will shake out. From an investment perspective, we watch and remain flexible to take advantage of opportunities as they arise.

In summary, we are bullish on the economy if we can get the vaccine rolled out more broadly or herd immunity becomes a reality. We think the faster growth will be in the latter half of this year and the first half of 2022. All eyes need to be on the vaccine. We believe the positive attributes that the economy displayed before COVID-19 can be resumed because this was not a recession driven by economic excesses. We think the stimulus was important to keep people and companies afloat until we get through to the other side. As we now know the construction of our government for at least the next two years we will be evaluating tax and spending policies to determine the impact on both the economy and the markets.

As you are evaluating your present situation and, ponder these issues, please let us know if we can be of service.

¹ Bloomberg