Looking Back, Then Forward

January 2021

All things considered, 2020 proved to be nothing short of a remarkable year for equity investors. Large-cap U.S. stocks (S&P 500) finished the year higher by 17.6% on a total return basis, and were outpaced by small-cap stocks, as the Russell 2000 rode a parabolic fourth quarter rally to a 20.2% total return for the full year. Abroad, emerging markets were a relative winner, the MSCI EM index rising 18.5% on the year, pulled higher by 20%-plus gains out of South Korea, Taiwan, and China, which combine to make up over 66% of the emerging markets index. Developed international markets also posted a positive return but lagged domestic and emerging market stocks, broadly speaking. The MSCI EAFE ended 2020 up by 7.8% as gains out of Japan and Germany, which account for almost 35% of the EAFE, offset a double-digit decline out of the United Kingdom and lackluster returns out of France, Spain, and Italy, among others. Notably, Japan’s Nikkei 225 index traded at an all-time high to close out 2020, which could lead to interest from momentum investors over the course of the coming year.

The rally in stocks from the March low through year-end was driven by unprecedented fiscal and monetary support provided by governments and central banks globally. In the U.S., cash sent to consumers intended to bridge the gap between the economic shutdown and an improved employment picture found its way into the stock market. Purchases of epicenter stocks, those most negatively impacted by the economic shutdown, and upside call options skyrocketed as day traders picked up the baton while institutional investors moved to the sidelines awaiting clarity on the economic path forward. But even as “reopening” turned into “reclosing” stocks barely noticed, powering to a new all-time high in early September. After trading in a wide range throughout October, in the wake of the election, the removal of political uncertainty allowed the S&P 500 to rally 11.8% from election day (November 4) through year-end, while the small-cap Russell 2000, fared even better, spiking 22.6%.

We expect the new year to be another profitable one for equity investors, driven by a combination of ultra-easy monetary policy out of global central banks, increased fiscal support, and global economic momentum spurring investors to take ‘risk.’ Stateside, smaller capitalization stocks could outpace large-cap stocks as small and mid-cap indices skew toward economically sensitive sectors poised to benefit as economic tailwinds build. Small caps led the Q4 2020 rally and were overbought at year-end. Excesses have been building and may need to be worked off either via the passage of time or pullback in price before the upward trend resumes. Expected return alone shouldn’t drive decisions surrounding large vs. SMid allocations, as drawdowns can be unsettlingly swift farther down the market cap spectrum. Great expectations are worth noting entering 2021 as S&P 500 earnings are projected to grow from an estimated $135 in 2020 to $165 in 2021, a 22% increase, while Russell 2000 earnings are expected to jump 141%. While we are constructive on domestic stocks, lofty expectations, bullish sentiment, and aggressive positioning/asset flows could spark a pullback in the 1st quarter. We favor small/mid-caps relative to large caps in the coming year but await a pullback before allocating additional capital there as small caps appear overbought and may need to work off some froth.

Abroad, the consensus view is decidedly bullish on the emerging world as developing markets provide greater leverage and potential upside should a global economic recovery take root. A weaker U.S. dollar is a tailwind, on balance, for developing economies, many of which import commodities priced in U.S. dollars. While we tend to side with the bull case for emerging markets in the coming year, we are mindful that rising regulatory risks in China could potentially derail the bullish thesis as investors may think twice about how much exposure to China is too much. On Christmas Eve, China’s government announced a probe into anti-competitive practices by Alibaba, the 2nd largest holding within the MSCI EM index. The investigation is viewed as a retaliatory measure for comments Alibaba founder Jack Ma made months prior related to outdated regulatory oversight provided by the Chinese government. The announcement of the probe and subsequent sell-off in Alibaba’s stock is a reminder of who is in charge in China, and if one of the country’s ‘national champions’ can be in the crosshairs, no company is safe.

Economic growth expectations for the Eurozone and Japan are far from lofty and valuations aren’t demanding, setting up a potentially attractive risk/reward scenario for international developed markets in the coming year(s). Monetary policy support from the European Central Bank (ECB), relatively attractive valuations, and investors remaining underexposed to developed international markets after a ‘lost decade’ could generate increased demand for European and/or Japanese equities. The MSCI EAFE index that tracks international developed market stocks has generated a total return of just shy of 71% since the end of 2010, which pales in comparison to the S&P 500’s total return of nearly 267%. The significant underperformance out of the EAFE versus U.S. large caps over the past decade combined with expectations of a synchronized global economic recovery taking hold leads us to conclude that a drastic underweight to international developed markets isn’t as easily justified.▲

Source: Bloomberg, Factset