What a Year!
This past year was one most of us would like to forget but it was – shockingly – a great year for investors in both stocks and bonds. The almost eleven-year-old growth streak of the US economy ended abruptly in the first quarter with the onset of the pandemic that continues to lock down most of the world. Massive demonstrations and some localized outbreaks of violence and destruction shook the US over the summer as frustration at years of unpunished police killings of unarmed Black Americans boiled over. As this near apocalyptic year drew to a close the US presidential election went off much more smoothly than had been feared but the President shook the very foundations of American democracy by refusing to concede his loss and seeking to undo it by both legal and extra-legal means.
Yet not only did the bond market continue its long rally but – after an initial dramatic sell off – so did the stock market. In the beginning of the year the bull market in equities that began in March 2009 continued but as news of the incipient COVID-19 pandemic began to get more serious the stock market began to weaken. The accelerating spread of the virus and the consequent lock downs led to a series of crashes. From its peak on February 20th through the bottom of the sell-off on March 23rd the S&P 500 lost 33.7% of its value, giving up all of the gains it had made since the end of 2016. Equity markets globally followed suit. The uncertainty froze credit markets too, leaving companies at risk of being unable to borrow. With growth and inflation expectations plummeting and investors seeking safety, the US Treasury ten-year yield fell sharply from an already low level of 1.5% to a new low of 0.52% on March 9th. According to Deutsche Bank this is the lowest rate ever recorded on long-term US government debt.
As economies shut down and markets crashed, Central Banks and national governments sprang into action. Saying that it was “committed to using its full range of tools”, the US Federal Reserve announced on March 23rd that it would relaunch its massive buying of US government bonds to the tune of $500 billion, this time together with $200 billion in purchases of mortgage-backed securities and a suite of programs to make financing available to corporations, municipalities and consumers. A few days later Congress passed the $2.2 trillion CARES Act, extending and increasing unemployment benefits, sending direct payments to most taxpayers and establishing programs to support employment with loans convertible into grants for businesses and non-profits. Other developed nations introduced similar measures, many of them far more extensive as they essentially paid workers to stay home.
But Why did the Stock Market Do So Well?
These programs did the trick. The US stock market stopped falling the day the Fed announced its measures and soon resumed rallying to new all-time highs. By the end of 2020 the S&P 500 had risen 16.3% for the year. Corporate bond issues and stock offerings came roaring back. Long term interest rates rose as well, but at 0.93% on the ten-year Treasury at year end they were still slightly less than half what they had been a year earlier.
Yet the economy remains deeply troubled. The record heights reached by the stock market and a relatively low unemployment rate of 6.7% are coexisting with heartbreakingly long lines at food pantries, temporary and permanent closures of restaurants and other small businesses, and a potential wave of evictions as many people are unable to pay the rent. And the death toll from COVID-19 continues to mount. How can all of these things be true at the same time? If there was any doubt that the stock market and the economy are not the same thing, the last nine months look like definitive proof.
The most obvious and straightforward explanation for the stock market’s rally is the same factor that has been driving the stock market since the 2008-09 financial crisis: interest rates at record lows and support from the Federal Reserve. Additionally, the CARES Act put a great deal of money into the economy and investors are anticipating substantial additional relief funds under the incoming Biden administration.
A recent New York Times story (“Why Markets Boomed in a Year of Human Misery”, January 1, 2021) sheds further light on the question. As the economy partially shut down, most white-collar workers shifted to working from home even as many workers in non-essential businesses whose jobs had to be done in person were laid off. With higher paid workers largely remaining employed and the CARES Act pumping cash into the economy, total disposable personal income actually rose by $1 trillion from March to November, compared with the same period in 2019. At the same time travel was almost entirely cancelled while even those restaurants, bars, theaters etc. that remained open saw a sharp drop in traffic. Even though consumers increased spending on durables, groceries and other household items, total household outlays fell by $535 billion in the same nine-month period. The savings rate soared.
Much of that excess savings found its way into the stock market. A more perfect illustration of the widening inequality in American society could not be found. As my grandmother used to say: “Them that has, gets”. This is the “K-shaped” recovery.
Sustainable Investing Trends
In many ways 2020 was a banner year for sustainable investing. Investment in renewable power generation, electric vehicles and other clean technologies rose to a record $501 billion (Bloomberg, January 19, 2021) even as major oil companies such as BP and Shell wrote down the value of their oil fields and increased their investments in clean energy. US investors poured $30.7 billion into ESG funds in the first nine months of the year, compared to $21.4 billion in all of 2019, itself a record (Institutional Investor). Institutional investors increasingly consider ESG factors into consideration, with an industry survey showing that 88% looked for ESG capabilities when choosing fund managers (Ibid.)
Not coincidentally funds that avoided Environmental, Social and Governance risks did better than those with high exposure to those risks, according to Morningstar. 46% of funds that Morningstar rated as having a low ESG risk outperformed their benchmarks while only 30% of funds with high ESG risk were able to achieve the same outperformance. Investors’ increasing attention to ESG factors were clearly a driver of this outperformance. A further contributing factor was the weak performance of energy stocks due to depressed oil prices (energy stocks have now underperformed for twelve years) and the strong performance of pandemic resistant tech stocks.
In contrast the outgoing US administration continued its fight against clean energy, shareholder activism, and sustainability in general in 2020 but the financial markets were against them and the incoming Biden administration has clearly staked out a position in favor of sustainability, in particular the fight against climate change. One of the very first moves President Biden made on taking office was to rejoin the Paris Climate Accord.
With great fanfare, the outgoing administration opened the Arctic National Wildlife Refuge to oil drilling and rushed through an auction of drilling rights before leaving office. Before the auction, however, several major banks announced that they would not be financing oil projects in the ANWR due to the long-term risks to the oil sector from climate change. The lack of financing and the expectation that oil prices would not return to levels high enough to cover the cost of drilling for oil in a remote area with an extreme climate meant led all the major oil companies to stay out of the auction. In fact, the State of Alaska was the only bidder for the majority of the tracts to be leased and the auction raised a mere $14.5 million. The near failure of this highly symbolic move may make it easier for the new administration to cancel the lease agreements and permanently protect the refuge. The long running fight over the future of the ANWR seems to have ended with a whimper, not a bang.
The outgoing administration also lost a court battle over its regulatory changes to eliminate the Clean Power Plan, preventing it from undoing this key regulation.
The administration was more successful in its efforts to make sustainable investing more difficult. A new Department of Labor regulation – though watered down from the explicitly anti-ESG language that was initially proposed – requires retirement and pension plans to give priority to “pecuniary” considerations in selecting investments. Insofar as ESG factors are considered non-pecuniary this limits the ability of retirement and pension plans to offer ESG options. A new SEC regulation makes it more difficult for activist shareholders to propose resolutions at corporate Annual General Meetings. The Office of the Comptroller of the Currency pushed through a last-minute rule blocking the major banks from refusing to lend to the energy and weapons industries, in response to announcements by major US and international financial institutions that they would no longer be extending financing to these sectors. The new administration looks to be the most committed to progress on environmental and social issues of any other in recent years, but it will take time to reverse these misguided and backward regulatory changes.
The nationwide outpouring of anguish and anger after the police killing of George Floyd in May has led many in the investment community and in company management to take a fresh look at their own track record on questions of racial justice. Those who have done so have had to face the inadequacy of their efforts so far. Interest in ways to better serve minority and underprivileged communities through both investing and better business practices has grown substantially. This kind of engagement needs to continue if the racial disparities in our society are to diminish.
What’s in Store for 2021?
After the many surprises of this past year ,it would be foolish to assume that we know what will happen the next twelve months. There is clearly light at the end of the tunnel with respect to the COVID-19 pandemic, as vaccines are beginning to be administered across the country and internationally, albeit at a frustratingly slow pace. The new US administration is already taking a much more hands-on approach to managing vaccine distribution and testing. The Biden administration has also announced an ambitious relief plan to support individuals and the economy as a whole through the ongoing crisis. This gives many the hope that after a few more difficult months the pandemic and its attendant economic difficulties will ease, and normal life will start to return.
Just what will that new normal look like? It is not likely to be a simple return to the status quo ante. The pandemic has exposed a host of inequalities and inefficiencies in our society and our economy that should preclude just going back to the way things were. The new Biden administration has already made it clear that it will be ambitious in addressing these issues. We are likely to see a concerted effort to address economic inequality, which could lead to increased spending by lower income consumers. The new administration’s commitment to addressing climate change should be very positive for the clean energy sector.
The way we live may also be different from what came before. Remote technology has clearly proven itself. As a result, remote working is likely to remain more common, Zoom calls may continue to at least partially replace business travel and telemedicine may remain a mainstream alternative to in-person doctor visits. In the shorter term there is likely to be a surge in spending on travel and all kinds of socializing, given the enormous pent-up demand from a society that has spent months in near lock down.
Given the abundance of savings to invest and near-zero interest rates, the stock market has already been quick to seize on the anticipation of better times ahead. This may pose some risks if the economic rebound later in the year does not meet expectations. A risk specific to ESG investors is that oil prices may rebound as the economy improves, although this is not likely to mark a long-term improvement in the performance of the energy sector. The risk in the bond market seems clearer. The combination of near-record low rates and the potential for higher inflation expectations as increased government and – eventually– consumer spending stimulates the economy means that interest rates are more likely to rise than not. Longer term bonds are not a very attractive proposition at this point.
And, of course, we are all desperately hoping for 2021 to be a better year than 2020.
Urban Larson
Principal
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