- Emerging-market equities had strong performance in January, yet their developed-market counterparts were generally negative. U.S. large caps and Japanese equities lagged U.K. stocks, which were modestly lower for the full month, while European equities had a steeper decline.
- We expect to continue seeing signs of an economic recovery emerge as COVID-19 abates and activity normalizes. In the meantime, fiscal spending and accommodative central-bank policy should sustain gross domestic product growth and eventually cause inflation to rise.
January set a high bar for memorability. Six days into the month, the U.S. presidential transition took a bizarre turn as thousands of President Donald Trump’s supporters gathered in Washington, DC, to protest the formal declaration of Joe Biden’s victory. Trump rallied the crowd to descend on the U.S. Capitol Building, where the historically tedious ritual of counting electoral votes in the U.S. Congress was just getting underway. This culminated in a violent security breach of the Capitol by a mob of protesters who successfully delayed—but did not stop—the vote count, while damaging property and causing severe injury to and loss of life both for police officers and rioters.
Trump was impeached by the House of Representatives for inciting an insurrection—the first president in U.S. history to be impeached twice. Still, perhaps the most consequential fallout of the riot was Trump’s permanent ban from Twitter, his preferred mode of public communication for much of the last decade. Two weeks later, Joe Biden was inaugurated as president under heavy security provided by 25,000 National Guard troops.
The U.K. and EU parted ways upon entering the New Year, finally fulfilling the Brexit referendum of 2016. They returned to separate political realms for the first time since 1993 (when the U.K. joined the EU) and distinct economic realms for the first time since 1973 (when the U.K. joined the European Communities).
Capital markets were resilient throughout the uncharted political waters that engulfed the first few weeks of January, with equity-market volatility actually declining during these events. Later in the month, however, volatility spiked as subscribers to WallStreetBets (a popular and irreverent community of equity-market speculators within the Reddit social-media sphere) triggered a classic speculative frenzy by focusing their collective trading heft on a handful of unloved stocks. Several hedge fund giants were briefly paralyzed by the amateurs’ coordinated trading bonanza. This shift in attention benefited smaller beleaguered stocks, yet weighed on broad market indexes as it detracted from mega-cap technology stocks that have been leading markets in recent years.
Emerging-market equities had strong overall performance in January, with gains in the Asia-Pacific region more than offsetting steep losses in Latin America. In developed markets, stocks were generally negative for the period—excluding U.S. small caps, which were among the best-performing equities. U.S. large caps and Japanese equities lagged U.K. stocks, which were modestly lower for the full month, while European equities had a steeper decline.
Fixed-income sectors, with the exception of inflation-protected securities and high-yield bonds, were also down in January. U.S. investment-grade corporate debt, global sovereign bonds and emerging-market debt had the poorest performance. Government-bond yield curves generally steepened across major developed markets for the month. U.K. gilt rates increased for all maturities, although more significantly for longer-term rates than shorter-term rates. Long-term eurozone government-bond rates also increased, while short-to-intermediate-term eurozone rates were mixed. U.S. Treasury short-term rates edged downward, and intermediate-to-long-term U.S. rates increased.
COVID-19 infection rates continued to climb around the world during January. U.S. daily case counts topped in late December, while the daily death toll peaked in mid-January. The pandemic’s foothold strengthened as new, more infectious coronavirus mutations that originated in the U.K. and South Africa began spreading around the globe—a disconcerting development that risked setting back timetables for a return to normal.
The new Biden administration worked with the Congress to confirm top-level cabinet positions, enacted a series of COVID-19-related executive actions, and began to tackle a range of other priorities. President Biden also began promoting the “American Rescue Plan,” which proposes a $1.9 trillion fiscal stimulus package that combines extended unemployment benefits and housing-related protections with tax credits for lower-to-middle-income families, along with funding for state and local governments, education, health care, small businesses and direct payments to Americans. Biden’s Democratic Party holds slim majorities in both houses of the Congress and can therefore enact budget-related plans without bi-partisan support; nevertheless, as January concluded, the new administration remained open to negotiations with moderate Republicans over a potential compromise.
U.K. Chancellor of the Exchequer Rishi Sunak announced a one-time grant program for hospitality, leisure and retail businesses at the beginning of January. The program pledges to appropriate £4.6 billion for grants of up £9,000, which the treasury projected would reach 600,000 businesses.
- U.S. manufacturing growth remained strong during January. Services sector activity returned to a high level of growth for the month after its strengthening trend was interrupted in December. New U.S. claims for unemployment benefits were volatile, reaching nearly one million per week in early January before declining to about 850,000 toward the end of the month. The overall U.S. economy expanded at an annualized 4.0% rate during the fourth quarter (after annualized changes of -5.0%, -31.4% and 33.4% during the first, second and third quarters, respectively) and contracted by 2.3% for the 2020 calendar year.
- U.K. manufacturing growth weakened during January after strengthening throughout the fourth quarter. Activity in the country’s services sector plummeted for the month after working its way out of a contraction in November and December. The U.K. claimant count (which calculates the number of people claiming Jobseeker’s Allowance) increased by 0.1% to 2.6 million in December, generally in line with elevated levels that have become the norm since last spring. The broad U.K. economy shrank by 2.6% during November after recovering for six consecutive months.
- Eurozone manufacturing activity continued to expand at a healthy pace in January. Services sector activity remained mired in a contraction that began in September. The eurozone unemployment rate held at 8.3% during December, having edged lower in prior months from a September climb. The eurozone economy contracted by 0.7% during the fourth quarter of 2020 (after changes of -3.6%, -11.8% and 12.5% during the first, second and third quarters, respectively) and shrank by 5.1% during the 2020 calendar year.
- The Federal Open Market Committee (FOMC) retained its existing monetary policy stance at its late January meeting. The federal-funds rate target continues to range between 0.0% and 0.25%, and the FOMC remains committed to purchasing Treasurys and agency mortgage-backed securities (MBS) at respective rates of $80 billion and $40 billion per month.
- The Bank of England’s Monetary Policy Committee did not hold a meeting in January. It abstained from new actions during its mid-December meeting, having just committed in November to a new £150 billion toward bond purchases (for a total of £895 billion). Its next scheduled meeting is on February 4.
- The European Central Bank (ECB) made no new monetary policy changes at its January meeting after increasing the scale of asset purchases associated with its Pandemic Emergency Purchase Programme (PEPP) by €500 billion to a total of €1.85 trillion in December.
- The Bank of Japan (BOJ) held firm at its January meeting. BOJ Governor Haruhiko Kuroda indicated to the press that a monetary policy review available in March will consider how to eventually begin unwinding the BOJ’s deep market interventions since the global financial crisis.
U.S. equity performance diverged along capitalization lines in January, with large caps declining and small caps delivering substantial gains. Our U.S. large-cap strategies slightly underperformed their benchmarks on poor stock selection, which offset beneficial exposure to the stability alpha source and an overweight to the outperforming health care sector. Our U.S. small-cap strategies continued to generate elevated absolute returns compared to historical small-cap performance, but they trailed their benchmarks for the month. Exposure to smaller-cap companies contributed, while our high-quality bias detracted in an environment that favored companies with high degrees of financial leverage over those with higher profitability and accounting quality. Overseas, our international developed-market equity strategy performed in line with its benchmark, which trailed US equities for the month. Solid company-specific performance in the materials and consumer sectors contributed, while value exposures detracted. Our emerging-market equity strategy had strong one-month absolute returns in a historical context, but lagged its benchmark. A headwind to the value alpha source and an underweight to technology-oriented companies in the Asia-Pacific region were the top detractors.
Our core fixed-income strategy slightly trailed its benchmark during January as non-government fixed-income sectors narrowly outpaced comparable U.S. Treasurys. An overweight to the long end of the yield curve detracted as long-term yields increased. Positioning in corporate bonds was mixed; a mildly beneficial overweight was more than offset by an unfavorable underweight to utilities and selection within industrials and financials. An overweight to agency mortgage-backed securities (MBS) was slightly additive, but selection in specified mortgage pools detracted as more generic security types outperformed. A higher-quality bias in commercial MBS (CMBS) subtracted from returns as lower-quality tranches outperformed; although selection within higher-quality tranches was beneficial. Asset-backed securities (ABS) continued their solid recovery—benefitting our overweight, particularly exposure to student loans (our largest allocation) and to higher-quality credit-card and automobile securitizations. An underweight to taxable municipals detracted as they maintained higher yields than comparable corporate bonds. High-yield bonds were one of the few bright spots in the fixed-income universe during January; our high-yield bond strategy outperformed. An allocation to collateralized loan obligations (CLOs) was the top contributor, followed by selection in the energy and retail sectors. While only mildly unfavorable, selection in automotive, capital goods and financial services detracted the most. Our emerging-market debt strategy performed in line with its blended benchmark during January as foreign- and local-currency markets both declined. Overweights to currencies such as the Russian ruble and Brazilian real detracted, but a long position in the Turkish lira and an off-benchmark position in the Egyptian pound contributed. An overweight to Southern African nation Angola also benefitted from a rise in commodity prices.
Manager Positioning and Opportunities
U.S. economic growth in the near term will depend on fiscal stimulus and improvement in COVID-19 infection rates and vaccine distribution. Our U.S. large-cap strategies continued to underweight several of the largest-capitalization stocks in favor of more attractively valued opportunities further down the capitalization spectrum. High-growth stocks are generally expensive relative to the broader market; we maintained overweights to the health care, materials and financials sectors due to a combination of profitability expectations and reasonable valuations. Our U.S. small-cap strategies remained oriented toward value as it remained historically inexpensive. We decreased exposure to stability, although we retained a positive long-term outlook on the alpha source; a neutral-to-underweight stance on momentum should continue until a longer-term trend develops. Our international developed-market strategy maintained overweights to the information technology and industrials sectors due to strong growth opportunities. It also remained underweight defensive sectors like utilities, consumer staples and real estate on limited growth opportunities and elevated valuations. Our emerging-market equity strategy maintained an overweight to information technology on the sector’s growth merits, and to materials given a rebound in commodity demand. We remained underweight financials as a result of limited exposure to state-owned Chinse banks and lower-growth Taiwanese banks. We were also underweight overvalued communication services and low-growth consumer staples.1
With long-term yields remaining near historically low levels, our core fixed-income strategy continued to gradually reduce its overweight to the 25-to-30-year segment of the yield curve, while increasing positioning within the 7-to-10-year segment. The strategy decreased its overweight to corporates, both within industrials and financials. As a result, we increased our allocation to Treasurys given their liquidity and longer-term yields near the high end of recent ranges. Overweights to ABS and CMBS were maintained (with an emphasis on higher-quality holdings) due to competitive risk-adjusted yields, while an allocation to non-agency MBS also remained. As we look to the eventual decline of central-bank support ahead of an almost-certain increase in deficit spending, non-U.S. exposures have appeared more and more attractive. Issuance has remained strong and sentiment continued to improve, but we think nominal returns may be more limited in the future. Our high-yield strategy’s largest active position remained an allocation to CLOs, followed by an overweight to basic industry. The biggest underweight was telecommunications, followed by capital goods, utilities and consumer goods. We expect the prospect of rising rates in developed markets will pose a risk to emerging markets as hard- and local-currency rates will also need to rise in order to maintain their relative attractiveness. Our emerging-market debt strategy retained an overweight to local-currency assets. Its top country overweights were to Mexico, South Korea and Russia, while the most significant underweights were to Philippines, Thailand and Indonesia.
We’re all looking forward to a better 2021. From the looks of it, investors have already begun to set their sights beyond the valley.
Recent market chatter has hinted at the notion of a “Great Rotation” in capital markets, suggesting that investors may have begun to favor value and cyclical sectors over growth names. While there has been some evidence of this, we believe it is too early to tell if this is the beginning of a major secular shift in equity investment themes.
In our view, several signs of potential normalization seem to support the prospect of a style regime change.
- Treasury yields started to tick up in October. However, we would be surprised if rates moved sharply higher in 2021.
- The development of highly effective COVID-19 vaccines has helped investors shake worries about the pandemic lasting indefinitely.
- Regulatory developments in the U.S. and abroad have hinted that the dominance of large technology companies may no longer be as straightforward, long-lasting or profitable as some investors have grown accustomed.
No one knows whether these changes truly signal a Great Rotation from growth leadership to cyclical and value-oriented areas of the market. Still, we expect investors will be willing to shrug off the likely prospect of more bad news in the difficult months that lay ahead—including, for example, slowdowns or pauses in the manufacturing, distribution, administration and uptake of COVID-19 vaccines.
Politics will also come into play, with potential to act as either a tailwind or a headwind. The Congress struggled for months to provide additional income support to the people and businesses most seriously affected by the economic disruptions caused by the virus. The lawmakers finally came up with a $900 billion compromise that is limited in scope and falls far short of what is needed. Most of the benefits are set to expire in March and April, and it does not address revenue shortfalls facing state and local governments. There’s a high likelihood that the Biden administration’s American Rescue Plan (or a variation thereof, pending negotiations with moderate Republicans) will succeed in getting more fiscal support to those who need it.
Policy depends on personnel, and the priorities of the Biden administration have already proven to be quite different from those of the Trump era. One of the most important nominations put forth by Biden is that of former Federal Reserve (Fed) Chair Janet Yellen as Treasury Secretary. A close working relationship between the U.S. Treasury and the Fed will probably be reassuring for investors in the near term since there is little doubt that the central bank will continue its extraordinary efforts to support the economic recovery in 2021.
Casting our focus across the Atlantic, the last-minute Brexit deal in December provided a Christmas gift of sorts, at least in terms of removing a degree of uncertainty. While a skinny deal is better than none, the UK’s long period of intense uncertainty has continued to a degree as the deal addressed the transfer of goods but not commerce in services.
Such barriers to trade tend to introduce economic inefficiencies. Post-Brexit, therefore, U.K. prices will likely move a bit higher, gross domestic product (GDP) a bit lower and supply chains a bit more unreliable.
Looking at the forward price-to-earnings ratio of the MSCI United Kingdom, MSCI Europe ex-U.K. and the MSCI USA Indexes, we can see that the U.S. market has consistently traded at a premium valuation over the past 15 years.
That premium has widened since 2017 and expanded significantly further in 2020. The other two markets have mostly traded at similar valuations to each other over time—but a major divergence began to develop in 2019 and became more pronounced in 2020.
U.K. equity valuations, in our opinion, reflect much of the bad news. Maybe it is time for investors to think about the things that could go right:
- First, of course, is the development and distribution of vaccines, which are expected to drive the global economy to higher ground in 2021. This should benefit the large energy, materials and industrial multinationals that make up nearly one-third of the market capitalization of the MSCI United Kingdom Index.
- The U.K. also appears competitive versus other advanced countries when measured by various benchmarks, such as relative unit labor costs.
- The government’s trade negotiators have already fanned out across the world to make sure that the U.K. retains the same trade agreements that it has enjoyed as a member of the EU.
Like so many other relationships in the equity market, the underperformance of the eurozone benchmark has been going on for a long time. Europe is more cyclical, value-oriented and less dynamic than the U.S.—but that does not prohibit a rebound in performance against the U.S. stock market at a time when the U.S. appears to be excessively tilted toward technology stocks, the U.S. dollar is weakening, and a global economic recovery is at hand.
The pandemic has had one good economic outcome for Europe. It finally forced Germany and other fiscal “hawks” to allow an expansion in fiscal policy. This move away from budgetary austerity should be viewed in context. Most countries have experienced a sharp rise in red ink during 2020, with the biggest deficits outside the eurozone. The Europeans probably can afford to run higher deficits than the International Monetary Fund appears to have penciled in for 2021. The memory of the European periphery debt crisis is still fresh in the minds of many policymakers who realize that pushing for fiscal austerity measures prematurely would probably be a mistake.
On the other hand, we think there is a greater need for other countries outside the eurozone to regain control of their finances. If those countries fail to do so, Europe could be the beneficiary of investment flows that would further prop up the euro and equity valuations.
Emerging-market equities have been on a tear since they bottomed out last March. However, the MSCI Emerging Markets Index is still just above its previous high-water mark recorded in January 2018. Frontier markets have fared even worse. The MSCI Frontier Emerging Markets Index (total return) has yet to surpass its most recent pre-pandemic high level recorded in January 2020.
Fortunately, not only has the combined firepower of global central banks prevented a liquidity crisis, it has also driven borrowing costs down to near-record lows—even as total emerging-market debt exceeds 200% of GDP. Only two problem debtors—Argentina and Turkey—had to increase their interest rates in recent months to stem investment outflows. As the world returns to normal, other nations may need to raise interest rates in order to attract sufficient investment inflows to sustain their fiscal and current-account positions.
A weak U.S. dollar is an important catalyst for emerging-markets performance. Although the currency weakened meaningfully in 2020 and pushed emerging-market equities higher, the performance of emerging markets relative to developed markets has been in a narrow range. We anticipate the coming year will see emerging equities’ relative performance improve, partly because the U.S. dollar is expected to continue to weaken.
If the world economy enjoys a durable cyclical recovery in 2021, the U.S. dollar should indeed sink further. A recovery would also bolster the rebound in commodity prices. Commodities of all sorts have been moving sharply higher since the spring, with metals, raw industrials and foodstuffs rallying together for the first time since the 2009-to-2011 period.
As COVID-19 abates and economic activity normalizes, signs of a recovery should continue to reveal themselves. In the meantime, fiscal spending and accommodative central-bank policy should sustain GDP growth and eventually cause inflation to rise. As the market prices in these developments, “long-duration” growth and expensive high-profitability stocks will likely be pressured—while momentum investors are expected to rotate into new themes, potentially adding more fuel to this nascent cyclical rally.
1 Individual holdings will differ between strategies. Not representative of our passive strategies.
Corresponding Indexes for Fixed-Income Performance Exhibit
U.S. High Yield - ICE BofA U.S. High Yield Constrained Index
Global Sovereigns - Bloomberg Barclays Global Treasury Index
Global Non-Government - Bloomberg Barclays Global Aggregate ex-Treasury Index
Emerging Markets (Local) - JPMorgan GBI-EM Global Diversified Index
Emerging Markets (External) - JPMorgan EMBI Global Diversified Index
U.S. Mortgage-Backed Securities (MBS) - Bloomberg Barclays US Mortgage Backed Securities Index
U.S. Asset-Backed Securities (ABS) - Bloomberg Barclays US Asset Backed Securities Index
U.S. Treasurys - Bloomberg Barclays US Treasury Index
U.S. Treasury Inflation-Protected Securities (TIPS) - Bloomberg Barclays 1-10 Year US TIPS Index
U.S. Investment-Grade Corporates - Bloomberg Barclays US Corporate Bond Index
Corresponding Indexes for Regional Equity Performance Exhibit
United States - S&P 500 Index
United Kingdom - FTSE All-Share Index
Pacific ex Japan - MSCI Pacific ex Japan Index (Net)
Japan - TOPIX, also known as the Tokyo Stock Price Index
Europe ex U.K. - MSCI Europe ex UK Index (Net)
EM Latin America - MSCI Emerging Markets Latin America Index (Net)
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding SEI’s portfolios or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.
There are risks involved with investing, including loss of principal. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments.
Diversification may not protect against market risk. Past performance does not guarantee future results. Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.
Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company (SEI).