Madison Client Communication | 4Q 2020


If in the depths of the Covid-19 market sell-off in March we had been told that 2020 would end with record market highs there would have been only one logical conclusion: by some miracle, the Covid-19 pandemic had been averted. Yet here we are at the end of the year seeing both U.S. stock market and infection highs. We've remarked on this seeming paradoxical coupling for a couple of quarters. Now, with a little more time and perspective, the reasons behind it are becoming clearer. And with that clarity comes some potential insights for the kind of investment environment likely in 2021.

But first a review of the fourth quarter and the year past. The stock market continued on the upward trajectory which began in April, with the S&P 500® Index rising 3.8% in December, for a quarterly return of 12.1%, bringing the return for the calendar year to a robust 18.4%. Digging a little deeper behind these benign numbers reveals some of the turmoil that was 2020. The Technology Sector soared 43.9% for the year, while Energy was the laggard, dipping -33.4. Powering much of the fourth quarter rally was the prospect of further fiscal stimulus from Washington along with unexpectedly welcome news regarding the speed of vaccine development and its efficacy.

Interest rates had dropped precipitously in March as investors fled to safety and as the Federal Reserve (Fed) stepped in by dropping its target rate close to zero. In the end this produced a solid year for bond investors. While the fourth quarter return for the U.S. Aggregate Bond Index was a modest 0.75%, the annual return was 7.36%, far higher than would have been expected given the relative low yields at the beginning of the year. Yields on the 10-year Treasury finished 2020 at 0.9%, a level below anything seen prior to this year.

An early analysis of 2020 income and spending patterns sheds quite a bit of light on the stock market resilience. While lost jobs have been potentially devastating to those affected, the stimulus checks, expanded unemployment benefits and job retention engineered by PPP grants have made a huge difference. Keep in mind that most of the lost jobs have been on the lower-wage spectrum with initial estimates showing a Covid-19 loss of some $43 billion in payroll in 2020, a significant amount, yet one that is dwarfed by the $276 billion in stimulus checks and $499 billion in CARES Act unemployment benefits. The end result of the stimulus has added up to close to a $1 trillion increase in disposable personal income. On top of this massive stimulus, consider the shifts in discretionary spending as travel and leisure activities have been stymied. Together with the fiscal stimulus this has pushed monthly U.S. savings rates up to an unprecedented high of 30+%. In the absence of attractive alternatives, money has flowed into stocks.

Given this unusual scenario, what should investors be prepared for in 2021? We trust the Fed's commitment to keep rates low for 2021 and well beyond. Easy money will incent corporations to be active in capital spending and in pursuing mergers and acquisitions as well as maintaining the currently robust housing market. The latest round of $900 billion in fiscal stimulus should keep the economy bounding and push more money into investable assets. However, with valuations already stretched, risk of a stumble also rises.

As the new administration takes control we have the prospect of higher taxes, increased regulation and additional spending. The economic fundamentals including rising Federal debt suggest future inflationary pressure. It's been a long time since the U.S. economy has had to deal with significant inflation and with the Fed bound to low rates inflation could be a longer-term issue even if high unemployment dampens the prospect for 2021. Still, inflation deserves close attention and we will be watching out for a weaker dollar, while keeping an eye of the expanding money supply, employment, wage expansion and overall GDP growth.

While initial vaccination deployment has been slower than hoped, the market is clearly focused on a post-Covid-19 economy in 2021. Even as we are fervent cheerleaders for this possibility, we are also aware that a market priced for perfection may not have the patience required should the vaccination effort take more time than expected or produce less than anticipated impact on the economy. This matches our general concerns over valuations. It had been our experience that overheated markets often overlook companies with the strongest fundamentals. In line with our belief that this low-yield environment is no time to add risk to bond portfolios, we are constantly monitoring stock holdings for downside risk, knowing that while bull markets can rise beyond expectations, they can reset in a heartbeat, often with the highest fliers taking the biggest dives.