Arrow's 2021 Market Outlook

2020 has been a year that most will remember for a series of unexpected events. The severity of the COVID-19 pandemic, and the escalation of lockdown measures were unparalleled in modern history. They were perhaps only matched by the extreme intervention by governments to inject economic stimulus and energize the healthcare industry to produce viable vaccines quicker than has ever been done before. While the market has been extremely volatile, with large market drawdowns in March, the rebound in the summer and fall has been equally extraordinary. With the U.S. election over, and many countries already beginning their vaccine programs, sentiment in the market has been positive, and many indexes will end up having a relatively “normal” year. The S&P 500 will post gains this year of over 16%, and the Dow Jones Industrial average over 7%.

Arrow has a positive outlook for economic and corporate earnings growth in 2021, with a continued low interest environment that favors equity over bonds. We do think there is some short-term risks however, with the logistical requirements of vaccine distribution becoming an obstacle to economic growth through the summer of 2021. Moreover, we think the market environment will favor a light rotation away from growth stocks towards value and cyclical equities, and from large cap to the extended market. We don’t expect this rotation to be long-lasting, or a hindrance to the growth of large tech companies, but these value-rich sectors are primed for increased investment as the world economy recovers from lockdowns. Arrow also expects international equities to perform well because of a weak U.S. dollar and the sector composition of international markets compared to the U.S.

Short-term interest rates will remain low; long-term might increase

Arrow expects the federal reserve to keep interest rates (short-term federal funds rate) close to zero in 2021. The federal funds rate drives the return of most stable, government backed investments, like short-term bonds and money market treasuries. In 2020, the federal reserve pushed interest rates lower in response to the COVID-19 crisis and instituted a series of programs to support the U.S. economy. The result of those actions was a good price appreciation on fixed income assets like bonds and TIPS, even though yield remained extremely low. With the increase in fiscal stimulus on the horizon, and many central banks allowing inflation to increase before raising rates, there is a strong possibility that 10-year treasury rates will increase from 0.9% to between 1.0% and 1.6%. Arrow expects an economic bounce that will drive yields towards the upper end of that range, particularly if vaccine rollout is robust, and economic recovery is strong by early summer. In contrast, short-term interest rates are likely to stay close to zero through 2021, as the Federal Reserve waits to increase interest rates until inflation rises. Inflation will likely increase eventually, but the Federal Reserve is positioning to increase inflation above its target of 2% for an extended period and inflation risk will likely be pushed to 2022 and 2023.

Arrow suggests keeping the bond duration (sensitivity to interest rate change) short in 2021 and increasing allocation into TIPS (Inflation Protected Securities) as inflation eventually increases.

Asset and Sector Performance in a post-COVID world

The vaccine rollout and potential signs of normalcy in the future has led to minor market rotation away from heavy growth stocks (technology) and towards more cyclical value-based stocks, and sectors that were hit hard in 2020 like tourism and transportation. We expect there to be some continuation of this in 2021 but expect the stagnation of earnings and growth in technology to be short-lived. Since growth stocks are more long-term in their expected return, we don’t recommend a change in long-term portfolios, but there is likely to be some movement away from growth as normalcy returns. Higher long-term bond yields will also help fuel more value-oriented sectors like financials, which have struggled in the low interest rate environment caused by COVID. Similarly, healthcare growth stocks have surged because of the amount of stimulus money the industry has received and we expect a similar rotation away from healthcare at least initially. We still expect long-term growth in the industry, particularly because of a Biden administration offering an expansion of the Affordable Care Act, and new research initiatives in genomics and mRNA vaccine technology.

One consequence of the Federal Reserve’s economic stimulus is the weaking of the U.S. dollar. Arrow expects the dollar to continue to move lower as relaxed monetary policy, large federal budget deficits, and international trade deficits will continue to grow. Financing the trade and budget deficits means attracting foreign investors, which is easier with a cheaper dollar. A weak U.S. dollar, and the reality that international stocks are currently weighted more towards cyclical and value stocks, offers good support that international diversification is important in 2021. Emerging markets like China, which haven’t suffered economically as much during COVID, are likely to perform well, especially with a weak U.S. dollar.

Real Estate Investment Trusts (REITs) were negatively impacted back in March and April, with many investors concerned about social distancing in commercial environments, and the possibility of widespread inability of people to pay their rent or mortgage. While this is still a concern in 2021 given high unemployment, REIT’s will likely do well if vaccine distribution goes smoothly and recovery from the pandemic continues. The U.S. housing shortage has driven home prices higher and helped buffered the industry from high unemployment, as there is a surplus of qualified home buyers relative to available homes.

Market risks in 2021

The primary market risks in 2021 remain uncertainty around vaccine distribution and effectiveness, but also the decoupling of valuation to earnings. A few months ago, the situation would have looked more dire, with uncertainty still surrounding the election, vaccine effectiveness, and economic stimulus. While there is still some controversy surrounding how effective the newest stimulus package will ultimately be, three of the major roadblocks to growth in 2021 have been resolved. The major risk now is that vaccine distribution remains slow, and infection rates continue to grow, even as people become vaccinated. If small businesses remain closed until the summer of 2021, there is still risk of further spikes in unemployment and mortgage defaults. It also remains to be seen if the economic stimulus just passed is enough to prop up the faltering U.S. economy, particularly with little stimulus being provided for American families. Further stimulus by the incoming Biden administration is another possibility that could help economic stability into the summer months.

Perhaps a more dire risk is the valuation of stocks themselves, is the extreme investor optimism that has driven the market into overvalued territory. This decoupling of stock price to earnings has the potential to fuel large corrections in 2021, so we expect volatility to remain for most of the year. Further, the disproportionate representation of growth-oriented technology and healthcare stocks in the S&P 500 (which represents most of the 2020 market gain), could lead to sharp reversals as investors rotate into more value-oriented stocks.