Conditions Supportive of More Balanced Equity Performance

ClearBridge Investments finds reasons for equity-market optimism in 2021.

    Scott Glasser

    Scott Glasser Co-Chief Investment Officer and Portfolio Manager, ClearBridge Investments

    The recent backdrop for equities is instructive in forming our views for the year ahead. 2020 has been a year of extremes, with the global COVID-19 pandemic leading to one of the sharpest but shortest bear markets on record that was immediately followed by the best ever 50-day rally for the S&P 500 Index. Equities ended the year on an upswing as two major uncertainties – the outcome of U.S. elections and the timeline for a COVID vaccine – were largely resolved.

    Liquidity is another significant determinant in framing our outlook. Whether judged by money supply, interest rates or credit spreads, liquidity is ample in the current environment and likely to remain supportive of equities in the medium term as the Federal Reserve stays accommodative in its policy approach. Increased liquidity is especially beneficial for small cap companies in accessing the capital markets for financing as well for the continuation of a robust IPO market. The beneficial effects of a higher liquidity environment tend to wane after 12 to 18 months.

    Given these factors, we have a moderately positive view for equities in 2021. Volatility has come down since the election to a level where we do not expect to see significant spikes in the VIX like markets experienced early in the pandemic or significant declines. Investor sentiment and earnings forecasts for the first half of 2021 have become a bit exuberant, which will likely lead to consolidation and perhaps a slight correction early in the new year. Longer term, we believe markets should head higher as the economy normalizes with the distribution of a vaccine and adjustment to a new presidential administration. Based on a green expansionary signal for the ClearBridge Recovery Dashboard, we also believe that a durable economic bottom has formed, providing further support for equities, which tend to perform strongly coming out of recessions.

    Exhibit 1: Following Recessions, Equities Typically Do Well S&P 500 Returns During Economic Expansions

    Source: FactSet, NBER. Past performance is not a guarantee of future results. Investors cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.

    The election outcome was very good for equities, which surprisingly tend to do best with a Democratic President and split Congress. This assumes at least one of the runoffs in Georgia will be won by the Republicans, allowing them to hold the Senate. The results take big tax increases off the table, but also lower the likelihood of a fiscal stimulus package in the $2 trillion range that Democrats have been pushing. We see the failure to pass some form of stimulus before the new Congress is sat in January as the biggest short-term risk to markets and the economy as many consumer assistance programs have already expired or will soon.

    The approval and distribution of a COVID vaccine is critical for the market and economy to get back on track. Positive vaccine results from three separate drug candidates in November immediately boosted the outlook for cyclical stocks, a broadening of market leadership that should continue into 2021. Vaccine distribution is a complicated task, however, and one we will be monitoring closely. Our base case is that high-risk groups and a good portion of lower-risk portions of the population will be getting the vaccine by the end of June.

    Given these tailwinds, we believe the cyclical and value-oriented sectors most severely impacted by the pandemic shutdowns look the most attractive. We expect the greatest increases in earnings growth will occur in these areas, as they will benefit from easier year-over-year comparisons and improving sentiment. The market has already responded to this anticipation for improvement and should continue to do so.

    Dividend paying stocks are a good example of a beaten up segment poised for recovery. Dividend payers did not display their usual defensive characteristics during the height of the pandemic, but instead suffered their worst performance in the last 20 years. Dividend stock multiples are at about 60% of the overall market, the lowest they've been in a long time, and should do well as the broadening of leadership continues. In an environment where we expect interest rates to remain close to zero, dividend stocks offer more attractive yields relative to fixed income and the potential for growing payouts.

    Simply looking at valuations would suggest technology stocks are overbought and most at risk of disappointing investors in 2021. Yet much of market forecasting is based on past analogs and we would argue that given the unique nature of the COVID-19 pandemic, which caused voluntary shutdowns of broad swaths of the economy, such analogs are not as applicable today. At current interest rates, technology valuations are well supported. Technology companies, which also include names in the communication services and consumer discretionary sectors, were direct beneficiaries of the shift to work from home and e-commerce. While valuations have expanded, growth has expanded as well and the major trends reliant on technology software and services remain in place. The pandemic accelerated those trends, making the digital parts of the economy larger, and we expect technology stocks will continue to grow faster than the overall market.

    In addition to taking on a more cyclical bias in 2021, we believe it’s important to continue maintaining exposure to these technology disruptors that are transforming the economy. A more balanced market should lessen the index concentration of mega cap growth stocks and we expect the equally weighted S&P 500 Index will outperform its market cap weighted counterpart in the year ahead. Smaller companies should also benefit from abundant liquidity, greater savings and the gradual normalization of the economy as vaccines become available.

    What are the Risks?

    Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.