February 02, 2021Institutional Investment Management

“An End in Sight”

State of the Markets

Let’s begin by reviewing what happened in the capital markets and the economy over the last quarter of 2020.  Short-term interest rates barely changed while the 10-year Treasury note yield increased 23 basis points, and the yield on the long bond increased 19 basis points.  The S&P 500 advanced 12% during the quarter, the NASDAQ advanced 16%, and the small cap index increased 31%. 

Annual volatility across all asset classes was pronounced during 2020, mainly as a result of the Covid pandemic.  Overall, most capital market segments ended the year with positive performance.  The Nasdaq reached a +45% annual return which was slightly higher than its performance in the prior year. US Large Cap stocks returned 18.4% while the US Small Cap index produced a 19.9% return.  International Developed stocks generated 7.87%.  At the same time International Emerging Market equities gained 18.3% over the year.  Weakened economic activity and the uncertainty of future profits fueled large price swings throughout the year, but ultimately capital markets are forward-looking, and so with progress being made on the pandemic, annual performance ended positively.

Expectations progressed with the first doses of the vaccine having been administered in late December.  Since there will be at least two companies with approved vaccines, the most vulnerable portion of the United States population should be protected by the end of the first quarter.  This will result in fewer fatalities and falling positivity rates as we move through 2021.  Economic activity will increase rapidly as 12 months of isolation begins to slowly wind down.  Schools will transition to in-person classes, recreational activities will resume, small businesses will gain customers, and restaurants will be allowed to reopen at greater than minimal capacity.  There may truly be an end in sight as we progress through 2021.

"There may truly be an end in sight as we progress through 2021."

GDP for the 4th quarter of 2020 is estimated to be close to 7.5% according to the GDPNOW forecast provided by the Federal Reserve Bank of Atlanta.  This comes on the heels of a 33% increase in GDP in the 3rd quarter.  Stimulus checks were mailed in late December and additional help will be debated in the coming weeks. We expect the unemployment rate will fall sharply by midyear.  Single family housing demand remains very robust as a desire to leave high population centers is combined with very low mortgage rates.  The Purchasing Manager’s Index (PMI) remains at expansionary levels.  Interest rates are extremely low.  Credit spreads for investment grade debt are currently near all-time lows and are at the same level as where we started 2020.  It seems likely that economic activity in 2021 will be quite strong given the pent-up economic demand and the accommodative fiscal and monetary policies of the US government.

Pension Plan Index Update – How low can you go?

Pension discount curve movements over the 4th quarter, as represented by the FTSE Pension Discount Curve and Liability Index, exhibited a decrease in rates across the maturity spectrum.  For example, the 1-year rate declined 0.10% over the quarter while the 30-year rate fell 0.16%.  A decrease in rates used to discount liabilities results in growth of the liabilities (for accounting purposes), and when a similar movement is exhibited in the treasury rate curve, an appreciation of fixed-income holdings.  The degree to which these two curves move in tandem and at what maturity points on the curve, can have a significant impact on pension funding levels.

Additionally, the liability discount curve can be summed into a single average rate.  Over the 4th quarter of 2020 that measurement decreased from 2.65% to 2.52%.  When the single discount rate is examined for the calendar year 2020, the reduction was more pronounced.  It began the year at 3.22% and so the annual movement resulted in a reduction over the year of nearly 22%.  In the end, interest rate movements over the quarter and the year had an increasing effect on pension plan liabilities.

The past year produced strong returns in risk markets as well as declining interest rates including those of fixed-income securities and liability discount rates.  With that combination of results, it would be reasonable to assume that the average pension plan gained substantial ground improving their funding status.  Surprisingly, that assumption would be incorrect.  As evidence, the Milliman 100 Pension Funding Index authored by Zorast Wadia, shows the largest 100 defined-benefit plans sponsored by U.S. public companies began the year with an average funded ratio of 89.8% and declined by year-end to a funding level of 88.2%.  The result was derived from the overwhelming effect of declining rates which increased the liabilities beyond that of the returns that risk-seeking assets produced.  Our conclusion of matching assets to liabilities has clearly been proven in a year with extremely positive risk asset returns.  Pension committees who focus solely on a plan’s total rate of return without attention to the value of the liability may be engaging in a fool’s errand if the goal is to provide a meaningful benefit to the participants while at the same time limit the impact of the plan on the sponsor’s financial statements.

"Our conclusion of matching assets to liabilities has clearly been proven in a year with extremely positive risk asset returns."

Interest Rate Outlook - Eat, Drink, and Be Merry

2021 offers the prospect of the pandemic subsiding and an element of certainty regarding the direction of the Unites States.  A change in the direction of the political pendulum will occur, but the narrow majorities in both houses of Congress may temper the magnitude of the changes.  If we look at the various initiatives that were mentioned by the new administration, they include infrastructure spending, additional stimulus dollars for some individuals, possible debt relief programs, the promise of increased healthcare services (including a single-payer option – “Biden-care”), and money to benefit schools, higher education institutions, challenged municipalities, help for healthcare systems, and many other compelling causes such as environmental justice (Green New Deal). 

Near-term, we expect rates will rise as the COVID vaccine becomes more widespread and the new round of stimulus dollars start to circulate. This could be further amplified by democrat plans to rapidly get an additional $2,000 per person stimulus checks in the hands of voters.  The pandemic is hitting some families hard, and others who have been less impacted are cautious about the prospects for their financial future.  The December ISM Manufacturing release, which had a surprisingly high reading of 60.7, up from 57.5 in November (a reading above 50 suggests growth) may tell a related story. The market interpreted the fact that a measure of manufacturing customer inventories was at 37.9, suggests that both demand and inflationary pressure will ramp up in the future, but what if the manufacturer’s customers are keeping inventories skinny because they are being cautious about their economic futures?  Caution seems to be the most prudent path as the pandemic has made a mockery out of most forecasts.

Our short-term call for higher interest rates, followed by an economy that stalls, resulting in falling interest rates, is partially due to stimulus programs, Fed/Treasury support, and vaccine euphoria, but it is also influenced by mean reversion influences and the expected flow of information in the coming months.  Sequentially, we should start with the flow of information and how that may season growth expectations.  As we near late February, March, and April, when people will have stimulus dollars in their hands, year-over-year comparisons may start to suggest strong levels of inflation.  Given the massive economic contraction in early 2020, comparisons in 2021 versus the same months in 2020 will suggest rapid growth. Any comparison to zero looks terrific and these “base effects” run the risk of making the market too optimistic about the true and sustainable pace of growth. 

In late December, Bloomberg data showed that more than 70% of global debt had yields that were below 1%, with almost 30% of the debt having negative yields.  The breakeven rate (a measure of inflation expectations derived from U.S Treasury Inflation Protected Securities (TIPS)) indicated that inflation is anticipated to exceed 2%, the highest reading since 2018.  The resulting 10-year Treasury real yield (the difference between a coupon paying 10-year Treasury and 10-year TIPS) fell to a record low of minus 1.12% at the start of 2021.  

Also of interest, credit spreads (the additional yield investors demand for taking on credit risk as compared to a like-term Treasury) have significantly recovered to the point they are near where they were at the start of 2020 (before the pandemic-related panic).  The combination of low Treasury yields and modest risk spreads at the end of 2020 have resulted in yields on high-risk borrowers reaching the lowest on record.  This could be an area of volatility in 2021.  Low yields have driven market-rate coupons of most debt lower, which adds to the interest rate risk. 

Our 2021 forecast may translate into a 10-year Treasury yield that trends toward 1.50% and could produce a spike that dabbles with 2.0%.  As debt burden concerns emerge, along with stubbornly low long-term job creation numbers, and the degree of economic damage caused by the pandemic become evident, a slow-growth reality will set in and yields may fall in late 2021 or early 2022.  We see the largest risk to this forecast coming from the Fed embracing yield curve control and other measures to keep yields low and further obfuscate market prices.  

"Our 2021 forecast may translate into a 10-year Treasury yield that trends toward 1.50% and could produce a spike that dabbles with 2.0%."

Please reach out to our team at Advanced Capital Group to learn how we can assist with your defined benefit investment management needs.