In 2020, everything changed. What comes next?
Progress on addressing COVID-19 could kick off a rotation into cyclical stocks.
Emerging markets offer potentially appealing growth prospects.
Investors seem increasingly interested in pursuing ESG and Sustainable Investment options in their portfolios.
The flood of global liquidity could keep volatility low and limit asset returns.
Each year, we consider the trends that could shake up economies and markets in the years ahead. This exercise is especially relevant entering 2021, after a year in which COVID-19 and its economic fallout shook up the entire globe. We expect the following themes to have an especially strong influence on investors over the next 12 to 18 months:
- An equity market rotation
- Emerging market growth
- A focus on climate-conscious investing
- Global liquidity
Time for a great rotation
We have been living through an unprecedented health crisis, leading to economic challenges around the globe. In past recessions, the true healing began once the cause of a crisis was resolved. At that point, market leadership historically has often rotated into cyclical stocks and small-caps. Our current economic crisis was started by a health crisis. We are on the cusp of solving that crisis, but we’re not there yet.
For the last several years, shares of companies that can produce growth independent of the economic cycle—a.k.a. secular growth—have led the market by wide margins. The pandemic-induced economic fallout widened the gap between secular growth stocks—mainly in technology—and cyclical stocks, as the world turned to technology to cope with lockdowns.
Widespread availability of COVID-19 vaccines and/or highly effective treatments will likely signal the beginning of the end of the crisis. We believe cyclical stocks will take the lead at that point. In retrospect, the fourth quarter of 2020 may have marked the beginning of this rotation: several vaccines showed very positive results in late-stage trials, and the cyclical energy, financials, and industrials sectors led the market after lagging for the first nine months of the year (see Figure 1).
The prospect of a rotation does not dim the long-term outlook for companies that can harness technology to drive secular growth. Stocks of these companies should continue to serve as important pieces of long-term portfolios. But investors may be overexposed to these stocks now in light of their outperformance in recent years and could risk falling behind if cyclicals take the lead.
We believe that periods of volatility may be good times for investors to evaluate their exposures to cyclical and secular growth stocks and to rebalance, if necessary. The possibility of a strong rotation is one reason to consider Fundamental Index® strategies. We believe that fundamental measures and value characteristics may reassert themselves eventually, and that investors could potentially benefit from being properly positioned if they do.
We also anticipate a rotation into international stocks after a decade of U.S. dominance. Timing will depend on how the pandemic evolves around the world. But this is a good time for investors to review allocations and to rebalance their U.S. versus international allocations if they’ve strayed from long-term targets.
Emerging markets have evolved
In years past, emerging markets tended to suffer disproportionately during global crises. This was the case in the Tequila Crisis of 1994, the Asian financial crisis of the late 1990s, and the global financial crisis of 2008—but not this time.
In fact, China was the only major economy with positive GDP growth in 2020, in part because the country controlled the virus better than many others (see Figure 2). The U.S. government’s attempts to weaken China’s global economic position seem to have backfired: China has diversified away from U.S. dependency, strengthening its outlook for the years ahead. Meanwhile, the country has many fiscal and monetary tools to support its economic health and leadership position among emerging markets.
China’s demand for goods and services helps to drive growth throughout emerging markets from Brazil to Indonesia, so a strong Chinese economy tends to be good for emerging markets overall. Low rates globally are another plus, because excess liquidity tends to flow toward opportunities for growth and higher yields, which are in greater supply in emerging markets. Moreover, developing countries’ younger, fast-growing populations should help fuel global consumption in 2021 and years to follow, creating a range of investment opportunities.
At the same time, the risks that have upended emerging markets in the past seem under control. On the whole, EM countries’ finances are stronger and less tied to commodity prices than they have been in the past. In addition, any weakness in the U.S. dollar would make it easier for emerging markets to service dollar-denominated debts, making their bonds more attractive.
For all these reasons, investors might consider increasing their exposure to emerging markets. We believe the best approach is to invest through a combination of cap-weighted strategies, which capitalize on these markets’ bias toward momentum, and fundamentally weighted index strategies, which systematically identify fundamental measures and value characteristics.
Investors turn their attention to climate
The past year may have marked a turning point on climate change. People seem to be feeling a heightened sense of urgency after witnessing record-breaking heat waves and wildfires from America to Australia, the most active Atlantic hurricane season on record, and countless other examples of the consequences of a warming planet.
Greater attention to climate change adds momentum to a growing trend in favor of investments that reflect investors’ environmental, social, and governance (ESG) priorities, as illustrated by Figure 3. We think high-net-worth (HNW) investors in particular will be highly critical of companies that they believe are indifferent to environmental concerns and may favor companies they view as contributing to climate solutions.
Technological innovation has made it easier for investors to express these preferences. The rise of fractional share ownership has enabled more investors to practice direct indexing—holding all of the individual shares in an index directly rather than through a fund. We believe more investors will use this approach to customize their portfolios based on their specific priorities.
The high tide of liquidity
The global economic crisis will leave a lot of scars. It will take time for employment to return to normal, for the service sector to recover, and for people to routinely eat at restaurants, attend concerts, and fly on planes. These scars will likely hold back the recovery, so central bankers around the globe are likely to nurse their economies by keeping interest rates very low for a long time.
The resulting flood of liquidity is a double-edged sword though. It is likely to support credit markets and suppress the volatility of risk assets. Yet with the risk-free rate of return near zero percent, this limits the return potential of financial assets. And low bond yields also could present challenges for retirees and other income-focused investors.
These conditions heighten the importance of diversification and the discipline to maintain strategic allocations based on long-term goals and risk tolerances.
Avoid paralysis and focus on the basics
Investors may feel paralyzed by the uncertainty caused by COVID-19. Yet simply leaving portfolios unchanged could be dangerous. After years of leadership by U.S. growth stocks, many investors probably are overexposed to these equities and are comparatively underexposed to cyclical stocks, value, international, and emerging markets. We recommend reviewing portfolios to make sure they’re appropriately diversified and positioned to benefit from a potential market rotation.
As you undertake that process, be careful not to reach too far for income. Remember, any pickup in yield comes with corresponding risks, so be sure to understand the risks before investing in higher-yielding securities.
Finally, we would like to remind investors not to run from intermittent bouts of market volatility. Instead, consider it an opportunity to reposition your portfolio, if appropriate, and to harvest tax losses. Disciplined moves like these can help make progress toward long-term goals—which is the reason to invest in the first place.
- To prepare for a market rotation, consider learning more about Fundamental Index® strategies.
- Here is an opportunity to explore information about cap-weighted index strategies for investing in emerging markets.
- Consider direct indexing as a way to customize index to ESG preferences.