Last year was a tragic one, yet global stocks were up 16% in 2020. U.S. stocks did a bit better. During the worst days of March, with pandemic fears rampant and the global economy falling off a cliff, very few (if any) would have predicted this year’s strong outcome for stocks.
In fixed-income, core investment-grade bonds gained a strong 7.6%, benefiting from falling rates as investors sought low-risk assets earlier in the year. Within fixed-income, flexible bond strategies and floating-rate loans materially outperformed core bonds during the last three quarters of the year. But they still have some ground to make up from the tremendous selloff suffered in March.
In the face of a challenging and chaotic year, our portfolios performed well. We executed two tactical allocation shifts that added value. And since May, broadly speaking, the active equity and flexible bond managers we invest with have outperformed their passive index benchmarks. There are reasons to believe prior years’ macro and market headwinds may be turning into tailwinds for our portfolio positioning.
For 2021, the likelihood of widespread vaccine distribution supports the case for an economic recovery beginning in the second or third quarters. Central bank monetary policy is almost certain to remain very accommodative for at least the next year or two. And fiscal policy is unlikely to be restrictive and could be stimulative, depending on political outcomes. This macro backdrop should be supportive of equities and other financial risk assets, at least for 2021.
Over our five-year tactical horizon, U.S. stocks continue to look expensive in absolute terms but not relative to extremely low bond yields. Meanwhile, non-U.S. stock markets—emerging-market stocks in particular—have much higher five-year expected returns than U.S. stocks. If the U.S. dollar continues its recent decline, U.S. investors in international assets would receive an additional currency return.
With the yield on U.S. core bonds not much higher than 1%, we have a high degree of confidence that their five-year return will be around that level. Core bonds still play a vital risk management role in our balanced portfolios as a potential safe haven during a deflationary shock. But we continue to believe investors need to diversify their bond allocation to include non-traditional sectors and flexible strategies, whose longer-term returns should be much higher.
The low expected return prospects for both U.S. stocks and core bonds emphasize the need for alternative sources of returns going forward. We think select marketable alternative strategies can deliver good returns as well as valuable diversification benefits across a wide range of macro scenarios.
Of course, we must assess the risks. In the next few months, there could be a sharp economic slowdown from pandemic-induced lockdowns and, potentially, inadequate supplemental fiscal relief. And the current extreme investor optimism leaves the market vulnerable to disappointment.
Longer term, two big concerns are the specter of inflation and China. Inflation risk is low today, but the release of pent-up demand once the pandemic is under control, at the same time deglobalization is constraining supply, could lead to an inflationary spiral. And given China’s outsized influence within the emerging markets, we are very focused on the risk and opportunity it presents. We are bullish long-term on China and emerging markets, but China is cutting back stimulus and we think trade and tech conflicts with the rest of the world could continue.
Financial market history teaches us: expect the unexpected; expect to be surprised. And positive surprises happen too. It’s important to note that although our base case is for a cyclical recovery, our balanced portfolios are built to be resilient across a wide range of potential scenarios. That said, we’d be happy to see our formerly contrarian views become the consensus in 2021 and beyond.
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