What to Expect in 2021
By: Craig Haymaker, CPA, Chief Operating Officer
2020 has been an unforgettable year – pandemic, quarantine (toilet paper is still hard to come by!), police brutality and civil unrest, greater focus on racial inequality/injustice, negative oil prices, record low interest rates, economic stimuli, and a wild presidential election. Will 2021 match the trials and tribulations of this past year? I think not. But reflecting on the major market events of yesteryear and predicting, or attempting predict, what the future has in store is the task at hand. At HedgeStar, our coverage has always been broad in that we provide services across all asset classes – equities, interest rates, currencies and commodities. Focusing on these asset classes, this article posits some considerations for market participants and risk managers as they plan for and evaluate what could transpire in the coming year.
Equity markets had experienced an undeterred bull run for more than 10 years following the global financial crisis. It took a pandemic to quell the momentum that investors had enjoyed for so long. Just when it seemed equity portfolios would plummet, our friends at the Federal Reserve (the “Fed”) stepped in for several market inoculations that buoyed returns and sustained the US’ financial health.
Turning our attention to 2021, analysts at several major financial institutions have varied perspectives on what the near future will hold. Goldman Sachs expects the S&P to end next year at about 4,300 points, indicating 17% upside to recent levels – an admittedly optimistic forecast predicated on improved earnings and a continued low-interest rate environment that remains favorable for corporations. Morgan Stanley and Wells Fargo offer a more temperate view with year-ending ’21 results for the S&P forecasted around 3,900, or 6% upside.
Those viewing 2021 with a skeptical eye are concerned about the potential for inflation and rate spikes due to increased federal spending on COVID-19 relief measures and additional asset purchases by the Fed. Several analysts also show concern for a worse-than-expected roll out of the COVID-19 vaccine given the initial round of vaccine distributions has proven to be complex. On the sunnier side, many are citing historical precedent for these bullish projections with the most recent example occurring in the second-year post-financial crisis. 1 Jeff Buchbinder, an equity strategist for LPL Financial, stated that "we think this bull market is set up potentially for a better-than-average first two years based on the experience during the 2008-09 financial crisis and an expected strong earnings rebound." He also mentions the pent-up consumer demand during the pandemic that should help bolster a recovery once the economy fully opens back up.
Rate watchers have had their fill of entertainment in recent years, even before COVID-19 began to sink its teeth into the US economy. From the June 2016 Brexit announcement that saw rampant volatility in LIBOR rates to an inverted treasury yield curve in March 2019, countless interest rate-centric market events had preceded an even crazier 2020. Perhaps most notably, the entire yield curve fell below 1% in March 2020 for the first time ever and ushered in a looming threat that rates could push below 0% in the US.
As we look ahead, the Fed has conveyed an expectation of low interest rates for at least three years and continued bond purchases until "substantial progress is made." While this has sweeping implications for borrowers of all shapes and sizes, “many financial institutions are bracing for a challenging start to 2021 with the possibility of slow lending growth in the consumer portfolio and an expectation that residential mortgage volume will slow as the refinance wave runs out,” according to Thomas Griswold, Managing Director of ALM First Advisory Services. Mr. Griswold continues by saying “it is reasonable to expect margins to be squeezed as asset yields remain constrained as spreads are narrow in many of the agency investment sectors.”
A COVID-19 spreading machine and political turmoil notwithstanding, the 3% trade weighted decline in USD seems downright generous. It appears that the currency markets view these issues as temporary –vaccines are en route, and president trump appears to be relinquishing power. To date, these resolutions have buoyed the dollar from further decline. But will it continue?
2021 is looking rather bleak, however, with many currency risk managers conveying concern over the impending effects of current US fiscal and monetary policy. According to RBC Global Asset Management, “the continued deterioration in fundamental factors such as U.S. fiscal and current-account deficits and relatively strong economic growth in the rest of the world are among the significant headwinds that should push the U.S. dollar meaningfully lower.”2
The Fed has been the first major central bank to indicate that it will allow, and even encourage, a period of higher-than-target inflation to make up for muted price changes in recent years. Known as “average inflation targeting,” outcomes from this tactic are expected to boost inflation and further depress real interest rates (nominal interest minus inflation expectations). RBCGAM continues by stating that “in the eight months since the end of March, real yields in the US have fallen to negative levels even as nominal 10-year yields rose. This gap is a direct consequence of investors’ expectations that US inflation will rise and has resulted in the US now having one of the lowest real yields among G10 nations.”
Commodities: Commodities are stereotypically cyclical assets, rising and falling in synchrony with the global economy. Thus, the broader commodity pricing malaise experienced in the first half of 2020 was largely washed out by China’s economic revival and purchasing resurgence in the latter half of 2020. While the outlook remains highly uncertain, many risk managers are anticipating a massive infrastructure investment during this time, even in developed countries. This infrastructural investment should drive demand in metals, such as iron ore, which should trickle down to oil. “We’ve already seen a metals-intensive response in China, highly metals-intensive,” Max Layton, head of EMEA commodities research at Citi, told CNBC via telephone. “It has been absolutely stunning how strong China has rebounded on the construction side of things,” said Mr. Layton. Apart from global enhancements to infrastructure, commodities investors are interested in two key drivers: 1) broader economic recovery and 2) the possibility of inflation. Traditional commodity price behavior places them first in line to benefit from an economic recovery driven by COVID-19 vaccines. Additionally, the Fed’s commitment to low interest rates is creating inflationary pressure, which could reinforce commodity prices. Nic Johnson, who manages about $20-billion of commodity index investments as well as a separate hedge fund at Pimco, believes commodities “will benefit from the global reflationary theme.”3 While investors may enjoy enhanced commodity returns, commodity consumers will surely lament the potential for rising input costs and raw material purchase prices.
Identifying the optimal hedging mix between risk mitigation tactics (forward-type derivative instruments) and risk participation tactics (option-type derivative instruments) will be crucial for risk managers attempting to navigate 2021 with confidence and poise. For example, interest rate hedgers may enjoy the low-rate environment for as long as possible while mitigating rising rates with interest rate caps/calls. Currency risk managers on the other hand may prefer FX forwards and FX swaps to lock-in rates on USD-based currency pairs.
Corporate leaders will want to revisit their own risk appetites, coordinate with risk, procurement and treasury teams, and refine their hedge ratios in an effort to reduce financial risk across all asset classes. Accounting departments will want to take credit for these risk reducing activities with hedge accounting so to soften earnings volatility and financial reporting outcomes.
1. Forbes Magazine, Here's How High The Stock Market Will Go In 2021, According To Wall Street's Experts by Jonathan Ponciano, December 21, 2020.https://www.forbes.com/sites/jonathanponciano/ 2020/12/21/stock-market-2021-outlook-goldman-sachs-morgan-stanley/?sh=54850b415afd
2. RBC Global Asset Management, Global Currency Outlook – New Year 2021 by D.Fijalkowski, MBA, CFA, and D.Mitchell, CFA, https://www.rbcgam.com/en/ca/article/global-currency-outlook-new-year-2021/detail
3. Bloomberg, Commodities Are Back In Fashion as Investors Get Ready for Boom By Jack Farchy and Nishant Kumar https://www-bloomberg-com.cdn.ampproject.org/c/s/www.bloomberg.com/amp/news/articles/2020-12-20/commodities-are-back-in-fashion-as-investors-get-ready-for-boom
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Craig Haymaker, CPA, Chief Operating Officer
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