There is a scene in one of the Back to the Future movies where Marty McFly is caught in a tunnel on his hoverboard, with his arch-nemesis, Biff, bearing down on him in a convertible. The intensity builds as the audience wonders whether Marty will make it out or get run over (spoiler alert: he makes it out). In a way, our economy is a bit like Marty right now – will it get run over, reach daylight, or perhaps make it out of the tunnel, but not in the way we all hope?
Though last year was, plainly, a train wreck for too many people and industries, it also saw many new opportunities created, both commercially and individually. With the knowledge that vaccinations are on their way, there seems to be a bright light at the end of the tunnel. Following are three possible endings to our time in the tunnel, and how we may invest accordingly.
December was another very strong month in terms of market performance, although it did not reach November’s lofty highs. In fact, one is hard pressed to find any traditional index that posted negative numbers for the month. Of the main indices we follow, only the Barclays US Treasury index posted a negative return (-0.23%), but it still finished the year with a positive return of 8.0%. All major equity indices we follow finished 2020 with double-digit gains, except for the Dow Jones Industrial Average (9.72%) and the EAFE (5.43%). It turned out to be a great year, yet the huge numbers do not tell the full story.
Gains were somewhat concentrated (think Amazon, Google, Tesla, and Apple, among others) and generally occurred on the growth side of the spectrum, although value did have its moments. The markets collapsed, recovered, and added value in record time. It truly was a wild ride! The economy bounced back from the steep decline in the second quarter, but will likely post a negative GDP number for the year. It is still somewhat fragile, especially in the travel, restaurant, and entertainment sectors, and will not get back to where it was a year ago for some time. Small businesses faced their toughest year since the Great Recession of 2008, and are not out of the woods yet.
Scenario #1: The Run-Over
Let’s look at the three scenarios I listed above, starting with the potential for the economy to get run over. This could occur if the government (local, state, and/or federal) implements further lockdowns, causing things to stall. In a situation where the government goes crazy with stimulus or other measures (e.g., monthly checks for all, forgiveness of all student debt, massive tax or regulatory increases, etc.), we may see some economic benefits in the short term, but would undoubtedly realize massive negative long-term effects. Small businesses could be wiped out, unemployment and debt would soar, the commercial real estate market could implode, and lofty equity valuations would be unsustainable. We have only to look to last spring to see how this scenario might play out.
In this scenario, investing would mean adopting a defensive posture, looking for undervalued securities, being careful with fixed income, and perhaps just holding cash, even with little or no yield, while also looking for opportunities to invest that cash. While it is necessary to cite this possibility, I think the chances of this playing out in full are remote.
Scenario #2: The Shaky Emergence
This scenario has the economy effectively shuffling out of the tunnel and into a fog. Yes, the worst would be behind us, but the short-term potential for the economy and markets might be limited until, or if, the fog lifts. This could play out if vaccinations continue to roll out more slowly than anticipated; if a new strain of the virus is not dealt with effectively; if the government imposes further lockdowns, but not a complete shuttering of the economy; and/or if stimulus measures do not work effectively. The path forward would depend upon how well the government helps to prop up the economy and ramp up production, distribution, and use of vaccines.
In some ways, this scenario is very similar to the one in which we currently find ourselves: with markets looking beyond the fog to sunnier days, but with the knowledge that there will be some volatility between now and then. Stimulus measures would be enacted, but perhaps would not meet the specific needs of the economy, and a general feeling of unease would settle in due to the lack of opportunity to use stimulus funds, etc. Positive feelings of pent-up demand would continue to grow, but could quickly turn to depression should that demand not be realized sooner rather than later.
While this scenario likely would not last long – after all, fogs do eventually lift – it could very easily describe the first quarter of 2021. Taking a long-term approach to investing would be most appropriate here, which would mean diversifying across spectrums and taking advantage of valuations (value vs. growth, international vs. domestic, emerging markets vs. developed international), but not loading up in any one area. We'd be specifically looking at opportunities that may be available in infrastructure (likely something coming from Washington this year), travel and leisure (all that pent-up demand should be released later this year), and financials as interest rates firm slightly (not rise, just firm a bit). Fixed income would likely mean more corporates than treasuries, and high yield. Laddering out securities would help mitigate risk and potentially add some yield.
Scenario #3: The Breakthrough to Daylight
The final scenario is one in which the economy exits the tunnel and is immediately bathed in bright sunshine. This could happen if vaccines are effective and widely utilized, no additional lockdowns are implemented and current ones are lifted, stimulus programs are focused and effective, and pent-up demand is released. Normally, one might be worried about painting a too rosy picture that could see a rapidly heating economy running headlong into the waiting arms of inflation and higher interest rates. Yet, given where we are at, those fears likely will not come true in 2021, as the economy is not strong enough at this point to let that happen.
Certain areas likely would face constraints and perhaps higher prices, but they have also been the ones most beat-up – think travel, leisure, and entertainment. In this scenario, the markets would likely move higher, though not at the rates we saw in the last half of 2020, as fundamentals would be allowed to catch up to valuations. Certain industries, as described above, would do very well, while some of the leaders this past year would take a bit of a breather (not dropping off, necessarily, but perhaps not leading for a while either). Fixed income would start to come to terms with the potential for somewhat higher rates, but the process would be slow, and opportunities would still exist. Unemployment would fall further, and the economy would approach levels seen a year ago.
Risks would include too much stimulus and the potential for inflation, higher regulation and taxes causing slower economic growth, and the markets getting too far ahead of themselves. Ultimately, I believe this sunny scenario is what we are facing for the second half of 2021, and perhaps sooner. The potential for an overheated economy is likely overblown, as the initial spurt of demand should settle down into a slower, but steady, growth pattern approaching 2022.
As we start the New Year, we will look for opportunities to take advantage of valuation disparities, diversify, and still provide downside protection. We are here and available to discuss your portfolio or any other issue you may have. Please call our Wealth Management department at (608.826.3570). We look forward to speaking with you.