In the fourth quarter, equity markets continued to rally for the third consecutive quarter and significantly outperformed fixed income. The US election result and positive news on Covid-19 vaccines helped more cyclical segments of the market to recover. Value stocks rose by 16% and had their best quarter since 2009. Even more spectacular was the performance of small caps, which returned 24%, erasing the underperformance vs. large caps for the year. Growth equities gained nearly 13%, underperforming over the quarter, but are still ahead by a wide margin for the calendar year. Rising commodity prices were driven by strong demand for industrial metals in Asia. Oil prices also rose, aided by the vaccine news.
The pandemic took a turn for the worse over the quarter. New infection rates rose significantly in Europe and the US, topping the previous highs. Limits to intensive care unit capacity and outbreaks in nursing homes forced governments to implement new stringent lockdown measures to slow the spread of the virus. In Europe and the UK, services are under pressure from the restrictions. In the US, the vicious autumn wave of the virus began with a time lag to Europe and the restrictions were less stringent. Therefore, negative effects on US GDP growth are likely not to be seen until Q1 of 2021. Manufacturing continues to show more resilience to the pandemic than the service sector – a trend that can be observed globally. Recovering demand for goods and lower sensitivity to social distancing, helped to keep manufacturing purchasing managers’ indices (PMIs) in expansionary territory. This is good news for equity markets, since goods and manufacturing still contribute significantly to index-level earnings.
Concerns over the rising caseload were overshadowed by the announcements from PfizerBioNTech, Moderna and AstraZeneca/Oxford in November, that their vaccines were effective in reducing symptomatic cases of Covid-19. An end to the Covid-19 crisis now appears to be in sight, but the path to recovery may still be bumpy over the coming quarters.
After approval by the authorities, how quickly these vaccines can be manufactured, distributed and administered on a mass scale will be crucial. It is worth noting the logistical challenges of the Pfizer/BioNTech and Moderna vaccines, which both require cold storage and are relatively expensive. Success will also depend on the willingness of the population to get vaccinated and the effectiveness of the vaccines against any mutations in the virus.
For equity markets, the vaccine announcement on November 9 led to one of the largest momentum changes in history. Hard-hit value sectors, such as energy, traditional retail, hotels, airlines and financials rallied, while the pandemic winners, such as online retail, health care and home improvement, lagged.
Exhibit 1: Asset class and style returns
From a regional perspective, emerging market equities rose nearly 20% and Asia ex-Japan returned almost 19%, both benefiting from renewed hopes of a cyclical recovery, a falling dollar and increasing global trade activity. Strong demand for medical supplies and tech products lifted Chinese exports to the highest monthly nominal level on record in November. South Korea, another beneficiary of increased technology demand, also showed accelerating momentum in its export industry, with the new export orders PMI jumping to 54.6 – the highest level since March 2011 – in November.
US stocks reacted positively to the election result, which contributed to the 12% climb for the quarter. The prospect of a less confrontational presidency under Joe Biden, together with a divided Congress that might prevent both tax hikes and a tightening of regulation for technology and health care companies, pleased the markets. Nevertheless, the Democrats still have a shot at completing a blue wave if they manage to win both Senate seats in Georgia in the run-off election on January 5, which could change the narrative. US growth stocks, which have benefited from the shift online caused by Covid-19 this year, underperformed after the positive vaccine news.
The last days of the year brought long-awaited relief for pandemic-stricken companies and households. US lawmakers in Congress finally agreed on a pandemic relief plan that will extend many of the CARES act support measures, including renewing direct payments to households and more generous unemployment benefits. Consumer spending was potentially at risk without further government support, making this an important step for the US economy in building a fiscal bridge to the other side of the pandemic.
Exhibit 2: World stock market returns
After the leaders of Poland and Hungary had effectively blocked the European Union’s recovery fund and seven-year budget because the funding was conditional on upholding the rule of law, EU governments finally found a compromise. This paves the way for a EUR 1.8 trillion financial support package, provided it is ratified by the national parliaments of the 27 member states. It was agreed that a significant proportion of the budget and recovery fund has to be spent on sustainable and green projects. The EU also agreed tougher climate goals for 2030, increasing the reduction in carbon emissions it is targeting vs. 1990 levels from 40% to 55% by 2030. This will lead to significantly higher investments in renewable energy and more regulation.
On the monetary policy front, the European Central Bank (ECB) increased the size of its planned asset purchases by EUR 500 billion to EUR 1,850 billion, and extended the horizon over which it will make these purchases by nine months to the end of March 2022. The caveat was added that purchases can be terminated early, if no longer needed, or extended, if needed. This is helping to keep bond yields down in the eurozone going into the new year, despite the expected large amount of gross government bond supply due to pandemic relief programmes. Less of a headline but still important was the fact that the ECB asked banks to limit dividend payments until September 2021 to support the stability of the financial system.
In the UK, the Bank of England announced that it would expand its asset purchase facility by a further GBP 150 billion. The US Federal Reserve also explicitly committed to purchase at least USD 80 billion per month of Treasuries and agency mortgage-backed securities until the committee feels "substantial further progress" has been made towards its inflation and employment goals.
The key takeaway for bond investors is that, despite market hopes of an economic recovery, government bond yields moved only modestly higher because of central bank intervention. This is also the roadmap for 2021. Rates and yields are likely to remain low for even longer. US 10-year Treasuries ended the quarter with a yield of 0.9%, slightly up over the quarter but down from 1.9% at the start of the year.
Exhibit 3: Fixed income sector returns
In the UK, house prices and November retail spending were up year on year, despite severe restrictions on activity. Nevertheless, the bigger picture is that GDP remains substantially lower than its February level leaving plenty of room for recovery once the vaccines have been rolled out. The quarter ended with a Brexit deal finally being agreed, helping sterling to rise 5% over the quarter. UK equities delivered over 12% for the quarter.
Exhibit 4: Fixed income government bond returns
The first quarter of 2021 is likely to remain challenging for the global economy. Disappointing economic data is likely to coincide with continued pandemic-related restrictions. So far, the market has broadly been willing to look through the near-term weakness thanks to the vaccine news and policy support measures but any disappointment on the vaccine front could lead to increased market volatility.
Investors will have to work hard to make sure their portfolios are generating the returns they need. We start this new economic cycle with valuations that are higher than is normal coming out of a recession. The fall in real rates has supported valuations but, with interest rates closer to their nominal floor, such a repeated boost looks unlikely in the years ahead. More than ever, the emphasis will have to be on identifying the regions, sectors and companies that have the strongest underappreciated earnings prospects, while seeking alternative forms of diversification beyond government bonds.1
Exhibit 5: Index returns for December 2020 (%)