MASTERCLASS: Fixed Income - February 2021
February 10, 2021
Jenna Dagenhart: Welcome to Asset TV. This is the year 2021 Outlook Masterclass. We'll cover how the economy is recovering from the COVID crisis, how the new administration could impact markets, and what to watch in the new year. Joining us now our three expert panelists Tom Wald, CIO at Transamerica Asset Management, Malcolm Polley, President and CIO at Stewart Capital Advisors, and Jake Weinstein, Research Analyst at Fidelity Investments. Everyone, thank you for being here, and let's start by going around and having you all share your predictions, key themes for 2021. We'll go into more of the weeds later in the program, but first, I'd love to get a sense of what you're thinking when it comes to the big picture. Jake, why don't you kick us off?
Jacob Weinstein: Great. Thanks, Jenna. First of all, thanks for having me. I'm very happy to be here today. Or I'm still here in my house, but happy to be with all of you on Zoom. So, 2021, the beauty of outlooks for the year is generally they're always positive. You never ask any of us coming to the year, it was going to be a terrible year. I'll just start off by saying I think we're going to have a pretty good year for the economy. For the markets, obviously, I think it's going to be a lot better than 2020. But if you think about where we came into the year from last year, just a comparison, I was asked the same question for my 2020 outlook. And remember where we were back then.
There were trade wars between the US and China. The Federal Reserve was actually cutting interest rates in response to weakness. And you just had general late cycle malaise across the world. And then you had this kind of uncertain thing that happened, that we talk about too much, this coronavirus thing. Now we're at the end of the year, and all things are looking brighter for 2021. Vaccines on the horizon, distribution across the world. And the thing about the markets and the economy that's important to think about is, are things getting worse or are things getting better? Things in my perspective are getting better from here. So, in general, I'm pretty positive about the economy and the markets going forward for 2021.
Malcolm Polley: And Jenna, I think... Again, thanks for having me as well. We're also pretty positive on the economy for 2021. You don't have the same issues in front of us. Of course, COVID as Jake had said, you've got a vaccine that's in process around the world. I would expect that that will certainly help, but it's going to take a while before you get the vaccine fully distributed not only across the United States, but around the world. And I think there's still going to be some hangover from what's going on with corona. The coronavirus certainly was the biggest issue for 2020. I think it will continue to be an issue for 2021 is to deal with after effects.
Equity markets came roaring back in the fourth quarter of 2020. To the point that it really doesn't leave in our mind a whole lot of upside left. We don't really see anything on the horizon that could create a big negative dislocation. We just don't think that there's a whole lot of room on the upside, even with some modest earnings growth. You could potentially get a little bit of help from margin expansion, but profit margins are quite high. And on the fixed income markets with interest rates essentially at zero, it's going to be very difficult to get much more than say, a 1% return in fixed income securities. So, we have a pretty benign look in terms of expectations for markets, which is going to mean people that need or want substantial returns might be a bit negatively surprised.
Tom Wald: And Jenna, again, thanks for having me on the show today. Very nice to be with you all today. One theme that I've written about in the Transamerica 2021 Market Outlook is what I referred to as the storm before the calm. What I mean by that is I think it's probably going to be a good year for the markets but might not necessarily be an easy year. And what I mean by that is, when you look at the current environment, we've got these wonderful vaccines ready for distribution, but it's going to be a few months for them to get to the general public. And in the meantime, we're looking at these absolutely tragic and horrific COVID-19 case numbers. I mean, exponentially worse than when the economy first shut down last spring.
And whether we could get another round of closures and shutdowns, which could in turn really slow the economy in the first quarter of 2021. And when you combine that with what looks like could be a lack of a complete relief and stimulus package from Congress, as we begin the new year, that could be the recipe for some downside risk and volatility. But the good news, in my opinion, is after those early months of the year, we could have a much clearer path as the vaccines reach higher percentages of people in the spring and summer, the economy really begins to open up and we could start to see a final leg of this economic recovery really kick up a few gears.
And with corporate profits also strongly recovering, all going on in this continuous lower for longer interest rate environment, this should provide for a quite favorable backdrop for investors. But we might not see that until, at least a few months into the year. So, this concept of a storm and then a calm is one that I've got my eye out for.
Jacob Weinstein: Well, I'm in New Hampshire, so it's snow, there's blizzard and there's wind, and it's bitter outside. But once it gets better the depths of December, the darkest it's ever been. So, I just, light ahead from here is all I could see from my perspective. I love your comparison to the weather. I completely agree with both you guys. You should always have caution when it comes to thinking about things. We never know what's going to happen. There could be some uncertain events. I mean, who would have known what would happen in 2020. At some point, there's going to be some sort of what we call cycle killer.
But what I agree with you guys is that while things will get better from an economic standpoint, the market already knew that. And so, the market was like, "Oh, things are going to get better because we've got fiscal stimulus, monetary stimulus." It can't get any worse from here, because earnings have been so bad, so therefore the stock market as a discount mechanism is basically expecting that things at some point are going to ultimately get better. You never know exactly when, it could be four months, six months, eight months, but directionally things should improve from there.
Now, I agree there's not going to be as much of a beautiful early cycle like 20%, 30%, 40% returns in 2021, because of the sharp snapback we already got, but directionally if things continue to improve in the economy, that just basically suggests that from an investor's standpoint, you should be thinking that markets on average will be going higher rather than lower from here. With volatility, but on average expect upward trajectory.
Jenna Dagenhart: Malcolm, are there sectors which could be hurt long-term because of this ultra-low rate environment and a pandemic-related business shift?
Malcolm Polley: I think that the businesses that are clearly going to be struggling in an ultra-low rate environment are those that really depend on spreads. So banking, particularly banks that rely almost exclusively on the lending side of the business are going to have difficulties. I mean, the cost of funds don't really go much below zero, you're not picking much on the spread side from the loans that you're making. And so, you really need to focus on either fee revenue from the business, and this is fee revenue that is consistent and grows over time like asset management fees, etc. Or you need to have a better business model and keep your expenses very low. So banking is going to be a rough place to be as are most financial services businesses that depend upon spread.
I think that the economy, particularly the economy that focuses on business spending is also going to struggle. And I'm talking about business spending in terms of travel, entertainment, etc. Because one of the things that we think COVID did was accelerate a trend into 2020 that was in place and was taking a while to take hold. I mean, zoom meetings are much cheaper and much easier to put together than a big conference in Boston or LA or someplace like that. And it makes it easier for participants to go in terms of the numbers of participants you can have, because you don't have to leave your office for a week or so. So, businesses that focus on business spending like business hotels, entertainment complexes, travel, business travel, business airfare, etc., are going to struggle.
As well, we think real estate businesses that are focused on office real estate, I mean I don't think you're going to see occupancy rates jump up dramatically above say 60% in the near-term future. Just as people have got used to the fact that working from home isn't so bad.
Jenna Dagenhart: And before we really hone in on the economy, I know we're all eager to talk about the recovery. Tom, what kind of opportunities to invest do you foresee in equity and credit markets?
Tom Wald: Yeah. Well, you know what, it's so interesting because every year at this time, I try and write down what I think are going to be specific catalysts for the markets to move higher or not move higher. And some years those catalysts play out, and some years they don't. But I think what's really interesting is you've got a totally different set of catalysts for the equity credit markets this year than we've had in the past. And part of it is really what this historic second quarter economic shock really did to the economy and the markets. We had such a dramatic decline in annualized GDP, negative 31% in the second quarter, which was partially or more than partially made up with a really, really strong third quarter.
But I think one of the catalysts is that markets are encouraged by the premise that we could get back to where we were last year, next year. So, in other words, we were not so far back that markets are looking at what point are we going to get back to pre-virus levels? Originally, there was concern this wouldn't happen until 2022 or 2023. But I think some of the consensus now and it's sort of what I ascribe to, is that at the end of 2021, we could be back from an aggregate GDP, and from a corporate earnings standpoint, as to where we were in 2019. And the market is kind of happy about that. So, I think those are two catalysts getting to aggregate GDP and corporate earnings levels pre-virus by the end of this year.
When we get there, we're going to have this ongoing zero interest rate environment that we didn't have before. We're also going to have a heavy fed open market activity of about $120 billion a month of large-scale asset purchases, providing liquidity. We'll probably have about, in the end, probably about $2 trillion in fiscal stimulus. So when you start to put that in a collective lens, even after the really big moves that we've had since last March, I think there's still some pretty good upside for stocks, and I have an S&P 500 target of 4200, for the end of the year.
And so, I think the real opportunity is that these catalysts play out, but they're not going to play out right away, I think it's going to be later in the year, so that's going to require some patience and discipline for investors. Now, I think what's really interesting about the credit markets is that, like stocks, they've had this tremendous recovery since the depths of last March, when both high yield and investment grade credit spreads, basically tripled over that same five weeks that the S&P declined by 35% or so. And since then, they've had a dramatic recovery. High yield bonds which had spreads as high as just under 11% in March, are now closing up the year just above 4%.
Investment grade that at one point was at 4% is now just slightly above 1%. So high yield is basically trading where investment grade was nine months ago. And that to me is a pretty wild surprise. But when you look at credit spreads being this tight and rates being this low, I think it does create, generically speaking, a very challenging environment for bond investors to get above coupon rates in the year ahead, so probably maybe 5% for high yield bonds, total returns, and 2% for investment grade.
But I think what's really important here is that this is a year where I think active bond managers really have the opportunity to really show what they're made of so to speak. Because if investors really do want to achieve excess returns above coupon rates in the bond markets, it's going to have to come from some sort of real credit expertise that's capable of identifying the types of opportunities that you're not going to find in passive indexes. And I think that's where any excess returns in the credit markets are going to have to come from.
Malcolm Polley: Yeah, I would agree with Tom. I think that the issue that bond investors are going to have to get used to in 2021, as they've started getting used to in the second half of this year, is some pretty extreme volatility really led by the fact that interest rates are just so low. You really can't make any money by betting on which direction interest rates are going. I've been looking at volatility in fixed income markets, specifically tied to the 10-year CMT, and we've had more six standard deviation daily moves in interest rates on the 10-year CMT this year, than we've had basically from 1929 to the beginning of this year. So, volatility in fixed income has gone through the roof. And I really don't think it's going to go down very much in 2021, specifically because interest rates are just so low.
Tom Wald: Yeah. That's a great point, Malcolm. I think what's really also interesting is really, the bond markets have now reached a point where past performance is no longer just referred to as not necessarily an indicator of future returns, past performance is now impossible.
Malcolm Polley: Right. Exactly.
Tom Wald: Because you have these long term returns on bond funds that go back, some of them as far as the 1980s, where we saw a 10-year bond of 15%, go down to 30 basis points over the course of 30 years. So, you look at total returns on bonds, and you say, unless you're up and go into deep negative rates, it is mathematically impossible to achieve those returns going forward. So, it really requires, as you said, sort of a resetting of expectations for that entire asset class.
Malcolm Polley: Right.
Jacob Weinstein: And I think you guys are bringing up two major points that are extremely important to think about. And these are important things to think about investing in general but apply probably more so now to 2021 than in recent years, which is valuations and strategic asset allocation. So strategic asset allocation, you guys are mentioning bond yields are low. And so, if you're not going to get your income from bonds or as much diversification from holding bonds, there might be something you got to do a little bit differently. So, if you look at the past 30, 40 years, a portfolio of US equities 60% and investment grade US or treasury bonds at 40%, that like pretty much did it.
You could have done some other cute things around the edges, but pretty much that gave you a great risk return adjusted Sharpe ratio. Going forward with interest rates as low as they are, that may not cut it. So, you have to kind of think about other different types of investments that may be able to provide different hedges in case of the fact you get volatility. So, when the market zigs and zags around, you've got some balance to your portfolio. Some of those particulars can be Treasury inflation protected securities, commodities, some different alternatives, factor exposure, style exposure. So, I just think right now going forward, things have been good, I mean it didn't really matter where you were invested in last year, all assets pretty much except cash went up. And cash was even slightly high.
Jenna Dagenhart: You could have thrown your money with a dart like some of the boards behind you, and you would have been fine.
Jacob Weinstein: Oh, yes. Those are my dart boards. They are very predictive of 2020 returns, but primarily I'm not very good at darts, and so I miss them all the time. But anyway, the other fact, and thank you, Jenna. Again, moving along here, the other thing that matters, I think a lot outside of evaluations... I'm sorry, outside of strategic asset allocation is valuations. And you mentioned it there with credit spreads. If everything goes up at some point, especially if cash flows are weak and profit margins are weak, evaluations will look extreme across the entire board no matter where you are. So, somebody who basically invests based on trying to find cheaper stuff hasn't been doing very good lately, because it's just the growth stocks and the things that are more expensive getting more price appreciation as you move along.
However, given all the positive price appreciation we've had, how much growth has outpaced value, for example, this may be a time where just the extremes of value versus growth are just so wide. You can't find this exact catalyst or exact timing or point, but at some point, it does seem like smaller cap stocks, value stocks, other beaten down type of securities from a relative basis, should at least be able to give you some of that potential price appreciation because they didn't really enjoy the gains as much as they had been. And the good news there is that those types of securities, small caps and values tend to do well when you have a global cyclical recovery, which basically goes in line with what I said. So, the economics line up, the valuations line up, and that just may be able to provide some other opportunities for a strategic asset allocation.
Tom Wald: Yeah, Jake. And I would agree with that. I think some of the things that I've been stressing in our outlook is the potential to see a meaningful regression toward value from growth in the year ahead. And as you mentioned, growth has just clobbered value over the past decade. But I think the question is, maybe what is changing in this environment to make it more conducive for value versus growth? We've had this long, even before COVID, we had this long period of kind of subpar two percentage trend growth in the recovery going all the way back to the financial crisis, which created more of a scarcity of growth profile that favored growth over value. And then I think that was really exacerbated this year, when we had a movement into a lot of these technology, stay at home type stocks that kind of really stressed what might be the new environment.
So, if you have the vaccines coming on, it changes the overall growth profile of the economy, and it changes consumer behavior. The question is, does that really facilitate a move into value stocks for different types of reasons than we've been hearing about in the last, even last few years? The analogy I like to draw is waiting for this value rotation. It's been like Samuel Beckett playing Waiting for Godot, it just never shows up. But some of the criteria this year, might lend itself more towards this value rotation. I wouldn't say rotation, this regression to the mean for value stocks in the year end. So that's kind of another broad theme that we're watching as well.
Jenna Dagenhart: You raised a great question too, what's changing? Because a lot of things are. Malcolm, are there demographic shifts occurring, both in this country and globally that are exacerbating or helping the economic fallout from COVID?
Malcolm Polley: Almost definitely. It's interesting as you look at the economic data, for example. The unemployment rate is dropping, in part because people are finding jobs, but also in part because people are leaving the labor pool. And that's really made up of two buckets of people, women who are staying home to care for family members, etc. But also, people from my generation, the baby boomer generation that are nearing retirement and they're just exit deciding, "We're going to exit the workforce, because we don't need this anymore." The average baby boomer is now over 65 years old. We are well beyond the point in time where our spending decisions are going to positively impact the economy. Because quite frankly, baby boomers on the net have been seeing net spending decline for at least a decade.
That's going to continue. And the fact that the millennials, even though the millennials are now the largest generation in history, they are not as large relative to the entire population as the baby boomer generation was at the same point in history. So even though the millennials are increasing spending, boomers are decreasing spending at a roughly equivalent rate. So, net on a headline basis, it looks like you're going nowhere. So, I think that that is the reason why GDP growth has had a very difficult time getting even close to where the Fed wants it, or the politicians want it to be. That's why inflation has had a very difficult time getting even close to where the Fed wants to be. And not just the Fed, but all around the world.
The United States is actually probably in the developed world in the best demographic position of the entire developed world. We have not had basically positive population growth from birth rate in a long, long time. And that's not going to change for some time. So modern monetary theory has certainly helped, and it'll work until it doesn't. But it won't by itself create inflation, because we boomers aren't spending. And you see that show up in the savings rate. The savings rate has exploded during COVID, in part because of the stimulus checks that were going out. People weren't spending it. They were just either putting it into savings or paying off credit card debt. And again, it's not something that we see changing over the short to intermediate term.
Jenna Dagenhart: Yeah, I'm glad you bring up inflation. Jake, do you think inflation is as big of a threat as some people are making it out to be?
Jacob Weinstein: Yeah, no. This is something top, and so in my mind, it has been for quite a while, and now it's actually getting questions about it, so we're prepared to provide some answers with research we've done. One thing to answer your question directly, near term, no. Inflation is still going to likely be weak over the near term, because there's still a lot of excess capacity in the economy, the labor markets, etc. However, where I do want to disagree with Malcolm on two factors is the demographic point. Yes, I agree with weakening demographics, and that's going to be a drag on growth. But that doesn't necessarily mean it's a drag on inflation.
Demand factors as you mentioned are definitely intact, I would agree. But on the supply side, there could be issues in the supply side that the aging demographics don't necessarily mean it's going to be disinflationary or deflationary. It could actually be the opposite. I'm not saying it's one way or the other, but these are just things that could happen. But the thing I think as also you mentioned, MMT. Yes, it hasn't been inflationary, but that's basically because we've been in a 30 to 40 year disinflationary, goods disinflationary globalization trend, where you actually could issue a ton of debt and not have it be inflationary. You can print a bunch of money and have it not be inflationary. Going forward, I should say that when you say it works or it doesn't, well where it doesn't work in my mind, is indeed if you get that inflation. Because then you can't print the debt, because then you're issuing the debt.
But with inflation, rates go up, and who's going to buy the debt as rates are going up in fear of rates going up? Fewer and fewer people. Ultimately, they will buy those, that paper, but at that point, you have higher interest rates, and it's costing the economy more and it's a drag. So, it could ultimately be a painful thing. The way to answer your question, Jenna, is near term. I don't think it's an issue. But these are things that I think from a secular standpoint, we've got to be paying attention to and be prepared for, in case they actually do happen. And that ultimately, I think, inflation is one of the bigger risks out there to the risk to nominal asset returns.
Malcolm Polley: I guess I would respectfully disagree. Having looked at demographics for five to 10 years now, one of the things that I've noticed is that your demographic trends are very highly correlated to GDP growth. And you see that in spades, when you look at the baby boom generation. You can look at the changing demographics of the United States, in particular, and with very good precision show where our changes in inflation have shown up. And if you think about it, it makes sense, because what's the largest driver of the US economy? It's the consumer. Consumers still represent two thirds of the economy. As goes the consumer, so goes the economy, so goes inflation.
There will be pockets of inflation driven my millennial demand. But the headline number, which is what everybody focuses on, whether you pick CPI or PPI or the Fed's preferred number, that headline number is going to remain subdued for some time, until we get to a point where spending from the consumer led by the millennials and then Gen Z is enough to push that number up, then you get a problem. Will it approach what we had in the 1970s and 1980s? We don't think so. But you're probably about a decade away from seeing that kind of result.
Jacob Weinstein: Okay. Yeah, I agree with that point. I don't think we disagree. So, I agree with you on the demand side, I'm just saying there's other factors that could play into it. Excessive debt, deglobalization, the fact we can't really globalize much more from here, ultimately impacting the supply side of the dynamic that could lead to it. And I think you're spot on, and it's why we've had low inflation is that a big factor of that has been the demand factor from demographics.
Jenna Dagenhart: Tom, I'm going to pass the mic over to you here. Anything you'd like to add about the economy?
Tom Wald: Yeah. I think it's very interesting and going back to what Malcolm said a couple of minutes ago, it's really nice to be on a panel with a fellow baby boomer. I often feel like we're kind of far between these days. So, I'm there with you. I think one of the offshoots of what we talked about in the last few minutes is, I think whether or not we get inflation in the next few years, or whether or not we get it in 10 years, I think that we're definitely in a lower for longer environment. This was kind of verbalized by Chairman Powell last August, when he said what their long-term inflation targeting is going to look like, and it's going to be symmetrical. And they're going to let, if we do get inflation, they're going to let it run for a longer period of time with lower rates in the market than previously expected.
So, from an investment return standpoint, we're really looking at this continuous lower interest rate environment for a longer period of time. And getting back to that baby boomer angle, we were the generation that was taught, invest long term in stocks and get the capital appreciation over several decades. And when you retire, park your money and get these nice 7%, 8% risk-free returns for the rest of your life. And the first half played out pretty well and the second half isn't there. So how we as a generation now, budget our investments for retirement becomes a very, very critical component of the economy, in my opinion. Because if we don't have guaranteed rates of returns, we either have to go out on the yield curve to get higher returns, where there's risk. We have to go out in the credit curve to get high returns where there's risk, or we have to go into principal, or we have to stay in the workforce.
And none of those four things are really kind of what we signed on for, nor are they really at the risk levels that are... Or what the economy would really want them to be. So I think what this means is, for the millions of baby boomers that are going to be retiring in the years ahead and have to really look at their portfolios and where they're going to generate their returns, they're going to have to find new sources for that, whether it's generating excess returns from credit, whether it's generating more income from equities, what have you, but it's going to require sort of a whole new wave of thinking, than what they were originally taught. And as they start hitting retirement age, that's really starting to sink in a little bit, and I think it's really going to affect portfolio positioning across the board in the years ahead.
Jacob Weinstein: Your point is exactly about the demographics issue that's interesting. A lot of people say, "Well, there's just demographics, age and demographics, so people have to buy bonds, and they have to." But a lot of the strategies we run are designed to do that. A lot of defined benefit plans are designed to do that as well. So, I do agree that on flow perspective, a lot of this debt is going to be purchased. But you stop and wake up and be like, "Wait a minute, why am I buying a 30-year bond that had negative real yield and locking that in? It doesn't quite make much sense." So that's basically what my point when I'm trying to say is, sometimes the market sort of falls asleep to all these things and looks backwards and then forgets about these forward-looking trends.
And if there is all this accumulated debt that comes out, fiscal deficit adding another two and a half trillion of Treasury debt, corporations still levering up because it makes sense for their valuations to do so, at some point, is there going to be a buyer for this debt? And I don't know. There has been so far, but these are the kind of things you guys got to think about longer term.
Jenna Dagenhart: Yeah. Where do investors go, Malcolm, in this low rate environment? What can investors that may be dependent on cash flows do in order to improve their portfolio of cash flow returns?
Malcolm Polley: That's a rough decision. It's going to be a rough issue that cash flow investors are going to want to look at. In bonds, obviously right now you're getting next to nothing in terms of the cash flow return. You could look at real estate, but there are many areas of real estate. First of all, we don't like the structure in most REITs, because of how they pay out cash flows. You've got issues in what type of real estate do you buy? Do you end up getting the cash flows? Mall developers are finding out because retail is in such a bad place right now that you're expecting decent cash flow returns from your rents, that's not going to happen.
I think that many office REITs are going to face the same thing, as well as many hotels faced REITs. So real estate is a difficult environment in our mind to invest today. There are really only a couple of areas that make sense to us for cash flow investors. One has a whole lot more volatility and that's preferred. And I would caution in that environment that most of the things that we see as what are called preferred stocks are really long-term bonds in preferred clothing. The other item that makes a lot more sense to us is dividend paying common stocks. If you look at the cash flows paid from dividends, what you'll find is even in times of dislocation, even in times like 2020, where you did have a lot of companies eliminate dividends, companies are far more reticent to cut them or eliminate them, because it's a shorter-term issue.
And cash flow paying or dividend paying common stocks over time unlike bonds, you should see your cash flows increase, particularly if you're going to hold for more than say, a year or two years, and you're looking 5, 10, 15 years out. The cash flow you get is going to grow over time, which is something you're not going to get in traditional fixed income investments. And so that's something we've been encouraging people to take a very hard look at. It's going to cause people that are used to buying bonds to kind of reset their risk expectations, and you're really going to need to get people comfortable with the fact that the principal value of what they own could move around a lot more than they're used to. But the cash flows themselves should be a lot more sticky and more reliable than what you should find in traditional fixed income investments.
Tom Wald: Yeah. After that, I think your point about the dividend income from equities is a really good one. And one of the metrics that really popped out at me during the COVID-19 sell off last March was when we began to see dividend yields on stocks move to higher yields in the 10-year Treasury which actually has only happened about four times in the last 60 years. It used to be a very common thing, going back and forth about 1960 that investors would look more to stocks for income than bonds, because the thinking was the equity dividend was at a higher risk, therefore you should get a higher yield. But then of course, as we moved into the 1960s, and kind of the criteria for stock investing really changed, it became more about internal growth and earnings than it was about dividend payouts.
But I think the broader point here being is I think we are in an era here where investors are going to be looking more to equities as a major component of their incomes going forward. And when you start to look at, "Okay, I've got X amount of money, and I've got to generate income for that in my retirement years, how do I get that income more and more that is going to come from the equity side of the equation?" And I think you could start to see investors recognize that kind of the age of certainty is over, the age of income certainty is over. And they're going to have to look to different parts of the portfolio to generate income. And some of that could be in more of an endowment type model, where they just have a balanced portfolio and say, "I'm going to take X percent out each year pro rata, and then count on the growth aspects to make that up going forward."
That's a far less definitive proposition than what I said earlier, just park it risk free and get that income going forward. But that is the environment I think we're going to be in and that's the change in the playing field that we're all going to have to get used to.
Jacob Weinstein: And I think that strategy has seemingly worked, because you've had the Federal Reserve and other central banks, basically, squashing all the volatility out of the market. So, if you have confidence, the central banks have your back from an asset holder perspective. Yeah, there's going to be some bumps in the road, but every time there's a bump, you got the Fed coming in, buying a whole bunch of QE, issuing whatever, doing programs, buying corporate debt, not letting the whole system fall apart. But I think there are risks. I mean, you were alluding to them. I mean, you're in a more volatile type of security, being in equities.
They do have dividends; it is an income. Obviously, you do have that volatility, but I think this interplay between asset prices and central bank activity has been very interesting, we can't overlook that. And that's why I just go back to my themes of what I look at is what's going to be able to basically stop the central banks around the world from being able to provide this type of liquidity and support to asset markets? And one of the... Again, just bring it up again, the limitation to that in my mind, which is not this year, is inflation. But it's something just to think about over the course. If it indeed happened, would central banks be willing to provide all the stimulus in order to kind of squash volatility, if it actually is a high inflation period? I don't know the answer, but just things to think about down the road.
Tom Wald: Yeah. But I think the reality is, for the investors, I mean for the Savers, that are going to have to live off their portfolio in some form of income, they don't have a choice. I mean, they're going to have to, if they're on a fixed budget going forward and they've got a portfolio at a certain market value, and they don't have income generating portions of that portfolio to provide that income, they don't have a choice. They're going to have to find that from other areas. And I think there's two aspects to the central bank accommodation globally, in my opinion. One is, of course, these huge amounts of direct monetary stimulus in the form of large-scale asset purchases, that are creating liquidity in the markets and obviously providing a boost there. And then there's the long-term interest rate environment.
So, one way to look at it is to say, okay, if you've got these historically low long-term interest rates, even with the move up in yields as seen in 10-year treasuries these last couple months, we're still historically well below anywhere we were prior to about 2016. And so, I think you start to look at stocks that are generating earnings and dividend yields, and those start to be compared to the long-term interest rates. And that creates in my opinion, somewhat of a floor on stock valuations if they're continuously being compared to low or no interest cash. And so, I think that provides some level of comfort for investors, that they can go to other places than just straight fixed income to find the income that's going to be necessary for them going forward.
It's by no means an optimal situation. There's no free lunch in all this. And like I said, the plan that was presented to this generation decades ago, played out on one side but didn't play out on the other, and it's going to take continuous analysis of comparative asset classes for them to meet in retirement what was presented a long time ago as pretty much a done deal.
Malcolm Polley: This idea that the central banks are able to take the volatility out of either interest rates or markets simply has not been borne out, particularly this year. Excuse me. As I said earlier, you've had more than six standard deviation daily moves in interest rates on the 10-year Treasury this year than you ever had combined. You've had more daily six standard deviation moves in equities this year than you've had, really since the Great Depression in the 1920s. At the margins, the Federal Reserve and central governments might be able to keep extremes from getting so large, but I think that where we are from an interest rate perspective, and simply looking at asset class returns, you're led to equities and it's simply something that has to be and people have to get more comfortable with the fact that they're going to have higher volatility.
I mean, listen, if you look at fixed income, look at any single fixed income index relative to their duration, for example. There is no scenario when you get 1% rates up move for any fixed income asset class that makes money. None. That's never happened in my career. Tom, I'm sure it's the same thing for you. And we're in an environment where the long-term normal for the 10-year Treasury is 4.5%. We're 400 plus basis points from there. So just to get back to normal, the negative returns that you're going to experience, and you could experience the fixed income investments will really force people to rethink, what is volatility? And quite frankly, the reason that you have dividends paid on equities, is to give people some compensation for taking that extra risk. It used to be historically dividends made up about two thirds of your return in equity returns. So, you're going to have some built in downside protection with the dividends. And I really don't think normalized asset allocation can work for quite a while.
Tom Wald: Yeah. And I think what's really interesting, I mean is, what are the expectations of what's going to drive the market? I'm sort of really very struck by what the similarity is of this market, when right now... So, I'm going back to 2011, when we came out of the financial crisis, the Fed went to a zero rate environment. They had what was then massive amounts of liquidity-driven stimulus and QE in the markets, which of course is much lower than where we are right now. But back then, it seemed huge. And when the market recovered, when we got back to aggregate GDP, when we got back to corporate earnings that were in line with the pre-financial crisis, the Fed stayed there. They stayed at zero rates, and they stayed at these large QE levels for about another three years. They stayed there from 2011 to 2014, on the large-scale asset purchases, and they stayed at zero rates in 2015.
So if that's kind of a precedent at all, where when we do recover, the Fed stays at these levels of large scale asset purchases, and they stay at zero rates, I think it presents a very good longer term landscape for stocks, because in part of that comparative earnings yield versus risk-free rates. And I think that's where the bulk of the returns are going to come on balanced or asset allocation portfolios, in my opinion. And I just don't see the Fed pulling the plug on either zero rates or some level of large-scale asset purchases anytime in the next couple of years. Because I went back to back in March, I gave the Fed a lot of credit. They were the first ones to really recognize just how much havoc, how much damage COVID-19 was going to wreck in terms of from an economic standpoint.
And when they cut the Fed funds rate from one and a half to zero, basically in 11 days, that was their stake in the ground as to how bad it was going to get, and how important monetary stimulus was going to be. So, I just don't see them pulling back at all in the next couple of years. And if we do get a recovery back to where we were in 2019, then I think that sets up a pretty good landscape to say, most of the excess returns are going to be coming from stocks.
Jacob Weinstein: Yeah. I agree with you into 2021, the point for the Fed rates low for the next couple of years. They got to figure at some point how to taper these asset purchases without having a taper tantrum. They don't want that to happen, like what happened in 2013 when the rate, the 10 year I think went from 1.5 to three in just a couple of months. They learned their lesson, so I agree with you, they're going to have to try to figure out a communication strategy or action that doesn't allow that to happen again. So, I would agree with you. But the huge difference here that I think compared to the last recession, was the last recession had basically you had tarp, a little bit of fiscal in 2009. Fiscal drag in the US, basically from 2010 to 2012, the fiscal cliff, we all remember, the fiscal drag and austerity in Europe, things have changed completely over the last 10 years.
More populist governments, more just willingness to issue debt and spend government money. And that's just basically positive for growth. So where it took kind of a while for asset markets to get their feet on the ground, even with the Fed as easy as it was last cycle, it was being helped a lot more by fiscal, and I would probably expect that to be the case and still be the case this year. But the risk is, if you do get some sort of complacency and fiscal drag in the US, that could have some sort of soft spot. But then I think you're right, the Feds just got to continue to just ease and ease and ease, and maybe even buy more to try to compensate for any potential fiscal drag. So, I think both fiscal and monetary are important to watch this time around as well.
Tom Wald: Yeah. And I think it's clear from what the Fed has said, they're looking for help on the fiscal side. I mean, they did so much this year, but at the same time, they're the first to say, "Hey, we need something from the fiscal side. We can't be the only game in town." So, I agree. I think going forward, you should be seeing more of a fiscal monetary mix than what we saw after the financial crisis. But there are certain realities that we have to recognize. And one is, how do you ever really get out of a zero-interest rate environment? Chairman Powell tried doing it in the second half of 2018, and we went all the way up to an upper bound of 3% on the Fed funds rate. I don't know if you remember that December, but a couple of Fed funds meetings, the markets were dropping hundreds of points by the minute as the Fed was making their statements and having the press conferences.
So, for better or for worse, there is that market expectation that the Fed will be there in tough times. And going down the road, that is something that investors are going to have to renew their expectations on. And I agree. I don't think that's going to happen anytime soon. But in the next decade, they're going to have to deal with how to move through these types of cycles, without the massive amounts of stimulus that we've seen in the last two cycles.
Jenna Dagenhart: Of course. The whole reason we find ourselves in this extremely low interest rate environment is because of the coronavirus pandemic. The Fed acted so aggressively to help combat the COVID crisis. Malcolm, what do you think the ongoing impact of COVID is? And how might a vaccine change those expectations?
Malcolm Polley: As I said earlier, COVID, I think really accelerated a lot of trends that were already in place. This idea of working from home, the idea that you don't really need to travel to have business meetings, zoom meetings, Team meetings, what have you, it's they're far easier, they're far less expensive. And I think that's going to remain in place. I think the idea of having conferences in large cities where you travel, and take a week or so doing travel, you may get back to some, but I don't think you'll get back to the level you used to have. Simply because, A, it's cheaper. It's cheaper to do it online. B, you can get higher attendance because for instance, I might be willing to send all of my staff to a conference virtually, but before, it might have been one or two, just from a cost perspective. Plus, it's more efficient. I can pick the sessions I want to go to.
What you lose on is really those people that are sponsors and exhibitors because you no longer have the foot traffic. So, you're going to miss out on all of that. We see that scale has become extremely important. If you don't have scale, you are going to struggle in times of economic dislocation. More so with the type of hopefully we never have to go through again like this pandemic. But small businesses have been throwing in the towel. Retailers that have been kind of walking dead for a while have been throwing in the towel. Business travel is going to change. I think that airlines that are focused on business travel are going to be hurting. Hotels that focus on business travel are going to continue to be hurting. We saw Palmer House declare bankruptcy earlier this year, because their occupancy rate has been running 20% plus. You can't make money with that.
So, I think we're going to see a real reset in travel and travel expenses, entertainment, entertainment expenses. Real estate, as businesses decide, "We don't really need 80% of our people downtown. They can be distributed throughout and not only our regional area, but throughout the country, because they can meet via Teams, etc." So that's a lot of the reset that you're seeing. And whereas purchasing on the Internet has become very important, and certainly companies like Amazon have done very well, it has become vitally important that if you want to sell things, you have to have that presence. And if you don't, you're probably not going to exist. Again, not new trends but trends that we thought were going to play out over a decade or more just got fast forwarded in 2020. And it really separated the winners from the losers pretty quickly.
Jenna Dagenhart: (silence)
Tom Wald: Yeah. Well, thank you for remembering that, Jenna, because I think anyone who's talked to me over these past six months or so, has heard me say probably 100 times that a successful development of a COVID-19 vaccine was the biggest wildcard not just for the markets, but really for all of global society. And now with both Pfizer and Moderna showing efficacy rates of about 95%, I think we can safely say that, that wildcard we were all looking for has turned up an ace, and boy, did we need an ace based on the hands we were all dealt earlier in the year. So now along those same lines, I would say that probably the biggest wildcard is now distribution of those vaccines. Because whether or not at least in terms of the economy over the next year or so, whether or not these vaccines get out to the broad mass public in three months, six months, nine months, I think it's going to make a real difference in terms of economic growth in 2021.
This is uncharted waters. These are logistics. You're talking about mass distribution of a vaccine to hundreds of millions of people in the US, billions of people globally, at the worst point of a global pandemic, which is something that's never been done before. And so, I think that to me, is a wild card, in terms of the economy and the markets in the year ahead. So that's kind of I think really... And we're all so happy that these vaccines are out there, and it was such great news when we saw the phase three clinical trials come out in the first couple weeks of November. And now I think we're moving to the next stage; how can this be accomplished? How can we actually get the vaccines out to the broad public?
I think that's going to have a bearing on economic growth, and to some extent, the markets. Over the next year, I think longer term, they will get out there, a couple years from now. Fortunately, I think almost everyone who wants to be vaccinated will be vaccinated. But these early stages of this process, I think are going to be really important. And I don't think anybody really quite knows how that's going to shake out.
Jacob Weinstein: I think Malcolm's point on how COVID has accelerated existing trends is the way to think about this. It's something that I think is obviously true, but most importantly from a policy standpoint. So, one of the trends we saw from a global political backdrop has been more populism. Think about the people who have benefited this year compared to those who have not benefited. In aggregate, the stock markets are up, asset prices are higher, house prices are higher. The rich are getting richer, the income inequality issue is kind of getting wider. And from a voter perspective on both the left and right in the US and abroad, I just think that this is going to maybe perhaps accelerate some of those political types of dynamics from a populace perspective.
And so, we'll see what happens. I don't know. But in general, if some populist type of policies isn’t good for asset prices, and so while it's been good for people on the higher income side, higher wealth side, it may not be the case forever. I don't think 2021 is the year to worry about that, but I started off talking about really positive things, and I guess the answer and unfortunately bring it down more negative, I think there's just more things on the horizon that can change and not have the world be the way it is exactly today that we should just sort of just be prepared for.
Jenna Dagenhart: Well, I'm glad you bring up politics though, because it wouldn't be a 2021 Outlook Masterclass, if we didn't talk about the 2020 election. Malcolm, what kind of impact do you think the new administration will have on the economy and on markets?
Malcolm Polley: Well, I think the impact is really going to be dependent on what happens in Georgia. We effectively have a divided Congress right now, at least until we get a result out of the Georgia senate race, where you could either have the senate move clearly to Republican control, or have it completely split and effectively be controlled by the Democrats. And how that result turns out, I think will largely dictate what happens from Washington's perspective. If we keep a divided Congress, which I think is ultimately better for the economy and better for markets, then the more extreme spending and taxing proposals that have been put out probably won't happen. They'll have to moderate them just to get the buy-in from the Republican Party.
If you get the democrats to take control of the Senate because of what happens in Georgia, then I think all bets are off in terms of what tax and spending proposals happen. Taxes clearly go up, capital gains rates go up, taxes on dividends go up. You'll see taxes on corporations go up, which net is bad for the economy. When you take money out of more efficient use and you give it to the government to spend, the government is not an efficient spender of dollars. They just aren't. So, I think what will happen from an economic perspective, we're really to be dependent on what we see coming out of Georgia. And Georgia becomes extremely important. History has shown that a divided government is actually better for the economy, and hopefully that will continue to be the case in 2020.
Tom Wald: Yeah. And I think one kind of specific point to what Malcolm was saying, is depending on these Georgia runoff elections, whether or not we see a tax plan coming from the Biden White House in 2021 and 2022, which as communicated by the Biden campaign during the election season, really has a lot of changes, essentially receding the tax cuts of 2017. Dealing not just with a higher corporate rate, I think they've suggested going from 21% to 28%. But also, in terms of things like capital gains and dividend income taxes, taxing at the higher end of the top brackets, also inherited taxes. It's just a lot of different areas that will be subject to higher taxes.
And the question is, how would the market respond to that knowing that might be coming towards the end of 2021 or into 2022? On the flip side of that, if the Republicans win both these races, they have a, what today is a fairly solid 52/48 majority, that could probably hold off tax legislation of that magnitude. So, I think that's a really important point of this January 5th runoff elections. I think there will be implications following that, either way.
Jenna Dagenhart: Jake, anything you would add about the 2021 outlook and the future administration?
Jacob Weinstein: I agree with both the panelists comments. Just think. It is not impossible, I mean, to envision there to be a 50/50 split in the Senate. I don't exactly know what would get pushed through or how it could get pushed through. But the markets perceptions right away would be reflation, infrastructure spending, tax on the rich, tax on the growth companies, and basically it would accelerate some of the reflationary trades between value overgrowth, and small cap over large, and the yield curve steeper that we've seen. So again, it's hard to kind of figure out how it's going to happen over 2021, but I think the market is going to basically respond as if it's going to be more kind of this current trend you see, but it just happens to be faster. That's kind of the one takeaway I'd have. And if it doesn't happen, I just think you get a slower type of reflationary trade that's going on right now to continue going forward.
Jenna Dagenhart: (silence)
Tom Wald: Yeah. Well, I think international equity could have some fairly attractive opportunities this year. And the reason why I say that is, kind of my view of international markets both developed and emerging, that have dramatically underperformed the US over the past decade is, what's kind of your big picture scenario that you want to be in either international developed or international emerging? And to me, it comes down to when they have accelerating rates of growth in their economy that are also at a premium to the US. So, over the past decade, we've heard a lot about premium growth rates internationally versus the US and cheaper valuations, which sounds like a great investment case.
But I think the reality has been that when global growth has been slowing, which we've seen since 2011, it's gradually gone from a 4% rate to a 3% rate during the past decade, we've only had one year in 2017 where international outperformed the US. And that actually was a year where it looked at that point like global growth rates and in both emerging and the developed economies were actually accelerating. So I think this year what we could be seeing is this global growth rate that's going to finish out 2020 at close to the worst ever, like a contraction of about negative 4.5%, but then we could see a pretty strong recovery globally up to like 5% and over 6% in emerging.
So, if you have that combination of accelerating growth directionally changing from negative to positive, and at a premium to the US, maybe this is the year where you really get rewarded for owning international developed and emerging markets. And I think I would be more likely to say that, that would be prone to happen this year than in the year’s past. So, I would say, there's a lot going on in terms of what's going to be necessary for the economic recoveries throughout the entire world, but I think it could be a good year internationally.
Jenna Dagenhart: (silence)
Jacob Weinstein: Yeah. I'm just an optimistic person in general, so maybe that's why it's the case. And I always want to think about investing in the markets. There's so much uncertainty, but it's really the long-term drivers that matter most for an asset allocation. It's the strategic way you're invested, knowing your time horizon, risk tolerance, all these different types of things. And there's really very few points in time where you'd want to just basically make wholesale changes to a portfolio. Even if you knew exactly what was going to happen in February and March and sold all of your stocks instantaneously, there are very few people that were able to actually time it well and have the courage and understanding and wherewithal to get back in.
So, we're paid to give these talks and we're paid to have some smart and brilliant ideas, and sound captivating, etc., but just the takeaway from all this is, think about the long-term. There's nothing in 2021 to suggest that anything is going to completely knock it off at stocks. But again, as I alluded to many times, understand the changes in the economy going forward and just use it as a guide to the future but not as an equation. So, try to think about the things that will be different going forward. And I've alluded to many of them, by demographics, inflation, MMT, debt, policy response, populism, politics, etc. Those are all the things you kind of want to think about, and then incorporate and make sure that you're just well set for your overall asset allocation.
Jenna Dagenhart: Well, everyone, thank you so much for your time and your insights. It was really great to have you.
Malcolm Polley: Thank you.
Jacob Weinstein: Thank you.
Jenna Dagenhart: And thank you for watching this 2021 Outlook Masterclass. We certainly covered a lot of ground with COVID, interest rates, the Fed and the new administration. I was joined by Tom Wald, CIO at Transamerica Asset Management, Malcolm Polley, President and CIO at Stewart Capital Advisors, and Jake Weinstein, a Research Analyst at Fidelity Investments. And I'm Jenna Dagenhart with Asset TV.