Moving past unprecedented. Positive COVID-19 vaccine news in the final months of 2020 has markets looking to 2021 with optimism — and hope for a return to something more “normal.” Highlights of our outlook for the start of the new year:
- Vaccine progress is a key market driver.
- We see a value resurgence with near-term staying power.
- Stock-level dispersion and leadership rotation augur well for active.
Market overview and outlook
The final quarter of 2020 will be remembered for many reasons, but perhaps none more consequential than the realization of at least three viable COVID-19 vaccines. Markets were cheered by the prospect of an end to the global pandemic and its weighty economic impact. Cyclical value stocks, those most beaten down in the COVID crisis, staged a late-year surge over growth stocks. We see value equities positioned for continued gains, but do not count out those growth companies with dominant and emerging business models that can continue to meet or exceed lofty shareholder expectations.
Many investors retreated to cash in a year of extraordinary uncertainty. We could see more assets make their way to equities in 2021 amid a market-friendly election outcome and a light at the end of the COVID tunnel. A resumption of buyback activity is another potential driver. The BlackRock Investment Institute, in its latest investment outlook, upgraded its pro-risk stance with a tactical overweight to equities.
“Are there risks out there? Of course. But there is also cash on the sidelines, pent-up demand and a vaccine in flight – potential for a roaring 2021.”
Ripe for rotation
This year’s turning of the calendar may be the most anticipated and welcomed of any in modern memory. After a fateful year that seemed to pack a decade of market and economic activity into 12 months, we see some key dynamics that may be ripe for rotation in 2021:
1. Active reactivated
The period following the Global Financial Crisis was generally marked by a steadily rising tide that lifted all boats. By the end of 2019, the S&P 500 Index had risen nearly 500% from its March 9, 2009 bottom. The U.S. economy delivered relatively stable and modest growth, fueled by easy monetary policy and low interest rates, while low inflation allowed the pattern to press on. As 2020 began, the cycle was aging and the stage set for greater stock-level dispersion. Then COVID-19 hastened the cycle’s end and ushered in a new recession/recovery, a backdrop that is already revealing winners and losers. This sets up a fertile backdrop for active stock picking.
In and around recessions, markets tend to get concentrated. We saw that in extreme fashion in 2020, as the top five S&P 500 constituents generated 127% of the index’s return during the first nine months of the year. It’s natural for that concentration to wane as the economy emerges from its downturn. We expect investors to begin to step beyond the “obvious winners” and deploy cash into beaten-down sectors and stocks that could benefit in recovery (see point #2). Generally speaking, this is where active investing can have an upper hand over index tracking.
2. Value comeback
Price did not matter for most of 2020 – at least not in the conventional sense. Investors weren’t seeking low valuations. Growth stocks supercharged by low interest rates, digitization, work from home and other pandemic-related trends were continuously bid up and led the market higher. It wasn’t until November, with positive vaccine news and election relief, that value took the mantle.
Make no mistake: Long-term growth is important and a big driver of earnings and stock returns. But in the near-term, we see an opportunity for value investors. While some growth businesses may be permanently accelerated by COVID, for others, the 2020 bump was a temporary pull-forward of demand. We’d put software and e-commerce in the former category and select consumer electronics in the latter. Cyclical value stocks, those with ties to economic growth and low valuations, have been most depressed and should enjoy a larger bounce with market and economic recoveries. In fact, changes in leadership are common arising out of recessions, with value tending to outperform in the early stages of recovery, as shown in the chart below.
Corporate earnings comparisons also could matter more in 2021. Many value cyclicals will have an easier time beating dismal 2020 figures versus growth companies with a much higher bar to pass to impress investors. Then there are buybacks, which slowed dramatically in 2020 and should resume in 2021. Buybacks are more accretive for value stocks, as buying shares at lower valuations (removing them from the market) has a greater proportionate impact on the value of the remaining shares.
Value has dominated coming out of recessions
Value stocks' excess return over broad index, 24 months after recession bear market
Source: BlackRock, with data from IDC and IBES. IBES earnings per share (EPS) estimates are used in calculating the forward earnings yield. Data is analyzed from Dec. 31, 1978, to Sept. 30, 2020, and the graph depicts the last five bear market periods that coincided with a recession. Bear markets defined as peak-to-trough stock price decline of 20% or more; recession periods as defined by the National Bureau of Economic Research. “Recession bear market” periods reflect monthly observations over the course of a recession-related bear market. Excess return of value stocks is calculated using the equal-weighted return for the top quintile of Russell 1000 stocks by earnings yield, rebalanced monthly, less the equal-weighted return for the Russell 1000 Index. Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index.
3. Dividends to deliver
Dividend investing fell short in 2020, even as the storyline seemed clear cut: Declining bond yields should have created demand for income-oriented stocks. Dividend cuts arguably scared investors away. The good news is that S&P 500 dividend cuts peaked in May and have since stabilized. We expect dividend growth to resume in 2021 as vaccine distribution and greater clarity in general give company managements the confidence to release excess cash in the form of dividends and buybacks.
With interest rates around the world set to stay low for longer, company dividends are likely to provide better income than bonds for some time. In addition, companies can and many often do increase their dividends whereas bond coupons are fixed to maturity. Dividend growth that compounds over time is a compelling proposition in an environment of sub-1% U.S. Treasury yields.
Tax considerations matter as well. Most equity income is taxed at a capital gains rate that is lower than the ordinary income tax rate paid by bondholders. And divided government means a low likelihood for tax changes that could have seen the dividend tax rate nearly double to more than 40% for some investors. One final tailwind for dividend stocks: Many of the COVID beneficiaries are low dividend payers. That leaves a gap for dividend growers to fill, even as appetite for these growth engines continues.
We also see some familiar patterns sticking around as the new year kicks off - and outline three in our full Q1 2021 equity market outlook.
BlackRock Fundamental Active Equity Investment Team