2021 & Beyond: An Investor Playbook for the New Business Cycle

While the COVID-19 recession will likely end in 2021, the impact of unprecedented levels of monetary and fiscal stimulus, plus structural changes to how we live and work that were accelerated by the pandemic, will make the world a different place. 

For investors, the emerging business cycle will create opportunities, but also challenges. For example, we expect to see improved productivity and faster global growth, but also higher inflation and rising long-term interest rates. Positioning your portfolio for this transformation will require a different playbook than the one that worked in the last cycle.

Over the past decade, a typical investor with a moderate-risk profile was likely to split her portfolio 60% stocks, 40% bonds, with the stock portion invested predominantly in large U.S.-based growth companies, mainly in technology—or simply an S&P 500 Index fund. That strategy worked remarkably well, overall. In the new post-pandemic market, that is likely to change. Investors should consider shifting their portfolios now, ahead of these emerging changes to market dynamics:

• Non-U.S. stocks may outperform U.S. equities. We expect the rebound in global growth to be faster than in the U.S., where valuations are stretched. China may be the world’s largest economy in the next few years and any companies linked to trade with China could outperform. Emerging markets, where valuations are attractive, may be the most favorable opportunity long term.

• Actively managed funds may beat passive index funds. Passive index funds outperformed actively managed funds over the past 10 years, as a rising tide, propelled by monetary stimulus, lifted all boats. Now, we expect to see more dispersion in returns across markets and asset classes. Investors will need to focus on the fundamentals of individual companies and sectors for results, which is why we expect actively managed strategies to outperform those that passively invest across an index. Successful investing may require shifts in asset allocation, sector, geography and security selection.

• Small-, mid- and (merely) large-capitalization stocks may do better than mega-cap favorites. Two key trends should benefit smaller companies. First, over the next decade, growth in the digital and social media powerhouses that dominate the S&P 500 may slow, while fresh innovators sprint ahead. Technologies at the forefront of the next decade of faster growth may include robotics, artificial intelligence and big data, creating opportunities for new smaller-cap companies to flourish. Second, the trend toward deglobalization could mean the return of various supply chains to U.S. shores, creating more opportunities for many small- and mid-cap U.S. businesses.

• Value-priced sectors could outperform expensive growth stocks. Many of the large-cap growth stocks that dominated the past decade are now very expensive relative to the broader market. As economic growth resumes, more attractively priced value stocks could have a chance to shine in the decade ahead. We suggest investors consider repositioning portfolios toward sectors that include financials, industrials, clean energy, construction, consumer durables and service-sector automation, while taking profits in the digital work-from-home leaders of 2020.

Higher inflation may mark one of the most important macroeconomic shifts in the new business cycle, with far-reaching effects for investors. Since long-term interest rates tend to rise (and bond prices fall) along with inflation, fixed income may no longer provide the portfolio ballast it once did. But nontraditional asset classes, such as real estate, natural resources or precious metals, could shine.

Also, higher interest rates would shift the balance between growth and value stocks. Growth-stock valuations depend, in part, on the so-called risk-free rate on a Treasury security. As government bond rates rise, so will the risk premium that investors pay to hold those stocks. That’s one reason why value stocks may outperform the handful of mega-cap stay-at-home equity leaders, which may not shine so bright post-pandemic. Indeed, we expect market leadership to shift to smaller companies in cyclical sectors centered on capital investment, infrastructure, housing and pent-up consumer demand.

The secular shifts that could yield new investment opportunities can be summed up using five terms, all of which start with the letter D. We’ve already mentioned two of them: Digitization 2.0 and Deglobalization. The other three include:

• Demographics: The impact of Baby Boomers on the workforce continues to fade, as Millennials and Gen Z make up ever-larger labor cohorts. COVID-19 may speed up this transition, leading more Boomers to retire and creating opportunities for Millennials to move up. This dynamic could result in a wealth transfer that fuels spending, just as Millennials, the oldest of whom are now nearing 40, are buying homes and otherwise reaching their prime spending years.

• Debt Monetization: Federal debt and deficits soared over the past four years, due to tax cuts, as well as the stimulus enacted to counter COVID-19 disruptions. With the Fed essentially buying all the new government debt, dramatic growth in the money supply is clearly inflationary. Unlike the financial crisis of 2008, when much of the growth in the money supply ultimately went into financial assets, this time, fiscal stimulus is aimed at individuals and small businesses. The reinvestment of these funds in the real economy, not just capital markets, has already sped up the economic rebound.

• Dollar Debasement: A rise in U.S. inflation would  lead to a decline in the value of the dollar against other major currencies. We expect the current level of monetary intervention to cause the dollar to weaken. If the Fed applies more stimulus to keep long- and short-term rates low, it will likely drive inflation through U.S. dollar debasement.

Here’s the good news: While bigger deficits, rising interest rates and higher inflation have traditionally been seen as negatives for markets, we see a bright future for investors, as conventional wisdom around these topics shifts.

Investors are slowly embracing the need for major fiscal and monetary policy change, which could entail greater government spending, including pandemic relief, as well as infrastructure spending, which may create jobs and boost incomes. Achieving these outcomes will likely require strong partnership at the government level.

We see the COVID-19 recession as a profound turning point, an opportunity for policymakers to pave the way for a new decade of broader, more vigorous growth. While the new business cycle presents challenges, we see significant reasons for optimism.  

This article is based on Lisa Shalett’s special report “Policymakers and the Pandemic: Defining a New Business Cycle.” Ask your Financial Advisor for a copy or find an advisor.