executive summary investment strategy overview

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December 20202021 Year Ahead: The Gateway to the New Frontier

3366527 12/2020

CHIEF INVESTMENT OFFICE

Investment Strategy Overview — Executive Summary

Investment Strategy Overview

The bull market for equities

continues in 2021, in our

opinion, and investors should

reassess their portfolio

allocations early in Q1 to

explore where they can take

advantage of this gateway year.

Christopher Hyzy

Chief Investment Officer

OVERVIEW ................................................................................................................................ 2

From a CIO view, what’s not likely to transition or shift materially in 2021? .............................2What type of potential risks should be considered for 2021? ...........................................................3What about capital market activity and potential asset allocation implications in 2021? ..4

MACRO ENVIRONMENT........................................................................................................ 5

What is the CIO’s outlook for the global economy for 2021? .............................................................5What is the productivity growth outlook and its implications for potential GDP growth in 2021? ............................................................................................................................................................................7

EQUITIES .................................................................................................................................. 8

What is the CIO’s outlook for corporate profit margins and its role in driving earnings in 2021? ............................................................................................................................................................................8Why does the CIO think we are currently in a secular bull market? .................................................9Does the CIO believe equities are currently expensive? What are the surprise catalysts that could drive valuations for equities, both positively and negatively?............... 11What are the prospects for International equities in 2021? Is it time to consider adding International to long-term portfolios? ........................................................................................... 12

FIXED INCOME ...................................................................................................................... 14

What are the potential implications of monetary and fiscal policy on interest rates, the yield curve and fixed income assets for 2021? ............................................................................... 14Could the coronavirus have a lasting effect on the muni market, and what might we expect in 2021 and beyond? ............................................................................................................................... 16

ALTERNATIVE INVESTMENTS ........................................................................................... 16

How should qualified investors think about allocations to alternative investments in 2021? ......................................................................................................................................................................... 16

MARKET STRATEGY ............................................................................................................. 18

How does the CIO see the outlook for China for next year? Are international trade frictions likely to continue as the U.S. transitions to a new administration in 2021? ........ 18How are the 2020 U.S. election results likely to shape the outlook for markets in 2021? ......................................................................................................................................................................... 19Is there a way to increase yield in a low- or no-yield environment, and what are the potential risks in doing so? .................................................................................................................................. 21What could a change of administration mean for sustainable and impact investing? ....... 22

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OVERVIEW

Following on our series that was produced this year called “The Book of Great,” which discussed 10 separate dynamics that developed in 2020, we believe 2021 represents a year of multiple transitions—“The Gateway to the New Frontier.” First and foremost, we believe this transition develops away from peak uncertainty to a more certain, albeit curious, environment. This would begin with a shift from various concerning coronavirus waves to vaccine advancements and distribution and encouraging therapeutics. In terms of the economy, it represents a transition back toward full economic recovery driven by a “Pent-up Demand Cycle”—the Fourth Phase of the Chief Investment Office (CIO) “Economic Recovery” within the workout process—away from shutdowns, phased reopenings and reimposed restrictions. The V-shaped rebound of 2020 evolves toward a reset in activity with new “learnings” across the Corporate, Consumer, Retail, Healthcare and Educational sectors. Businesses begin to transition back to a “work from the office” environment from the year of “work from anywhere.” Given the excessive pent-up demand, 2021 is a year in which the consumer begins to transition some of their spending away from goods back toward traditional service, such as, travel, leisure, entertainment, dining and lodging. Beginning January 20, a transition in Washington unfolds as President-elect Biden and a new administration begin their term. 2021 is also likely to include major shifts geopolitically regarding trade policy and the U.S.-China relationship, in general.

This gateway year is also a shift, in our view, to higher capital investment across most segments of the economy and should be the base year for onshoring opportunities. In addition, a gradual rise in productivity should begin to emerge as technological advancements, process automation, and tangible learnings from the pandemic environment spread throughout the private sector. As part of “The New Frontier,” plans for effective use of digital technology, software, sensory-based chip programs, and real-time logistics learning should take hold in areas more equipped to shift manual, human labor-intensive workloads to robotics and artificial intelligence methods (e.g., warehouse and factory automation, drone cleaning agents at stadiums, contact tracing software used for multi-purposes, movie theater “token” tickets for viewing first time anywhere, etc.). 2021 becomes the base year in which the “must-do practices” utilized during the pandemic era transition to “common practices” in the post-pandemic era. This is typical, in our opinion, coming out of crisis periods—particularly those that involve science and technology together.

The tangible transitions and shifts in the gateway year are likely to have wide-reaching effects on private sector profits, policy, and portfolio positioning in the year ahead.

From a CIO view, what’s not likely to transition or shift materially in 2021?

Let’s start with monetary policy. We expect central banks around the world to maintain ultra-accommodative policies and practices in 2021 as concerns linger around the sustainability of economic growth and the willingness for governments to maintain or develop new appropriate fiscal initiatives. Basically, in the U.S., an expansion of the balance sheet continues, and the zero bound in short rates is held, but we do not expect a sharp increase in longer-dated yields despite the higher deficit.

On the fiscal front, an additional stimulus package is needed to provide relief in key areas most harmed by the pandemic. Fiscal 4.0 is most likely to be smaller than previous bills but still targeted. A “relief” package in 2021 would come on the back of a stronger economy than earlier ones in 2020. Therefore, we expect growth to gather momentum throughout the year.



Furthermore, we believe consolidation, mergers and economic recovery workouts should continue in 2021 as oversupply is met with decreased demand in the areas that consumers have learned to either live without or have found replacements for during the shutdown and restricted reopenings. A lower level of economic activity in these areas generally requires a period of consolidation but can be balanced out with new industry growth that has been accelerated by the pandemic. This is where innovation takes over. Increased technological innovation generally leads to higher operating leverage and a potential acquisition cycle. This is also where the entrepreneurial animal spirits of the U.S. kick in, with the number of new business startups in the U.S. reaching record highs in 2020 and expected to remain robust into 2021.1

Housing should remain a core engine of economic and job growth in the gateway year following the powerful trend in 2020. Demographics, high savings rates, record low interest rates and low housing supply are driving this trend. We do not expect this to change anytime soon. Lastly, the profit and employment cycles should continue to surprise to the upside. As previously mentioned, a large increase in operating leverage, a return to full recovery status and synchronized expansion in the global economy mixed with expected record liquidity and relief could lead to record corporate profits in 2021, in our view. With record profits, we expect continued job growth that is solid but not necessarily powerful enough to drive the unemployment rate close to pre-pandemic levels. There are still too many areas—namely smaller businesses—that are likely to struggle to regain their footing even post-vaccine. We believe this will take time and likely last well into 2022.

Post-2021, “The New Frontier” (a new normal) would build and gather momentum to close out the final phase of the workout process, in our view. We expect housing and autos to continue to power the U.S. economy, capital investment to continue to grow at an above-average clip, onshoring to build, and infrastructure redevelopment to begin.

What type of potential risks should be considered for 2021?

Each year holds its own unique set of potential risks that could alter economic and capital market trends materially. Recently, we have experienced major risk mini-cycles in approximately two- to three-year rolling increments (2008/2009, 2011/2012, 2015/2016, 2018, 2020). In some cases, the risks were widely discussed (European sovereign risks, oil price collapse, Federal Reserve (Fed) policy tightening) and well-known, but the effect on asset prices was still sharp and changed market sentiment abruptly. In 2020, the healthcare crisis (i.e., black swan-type event) unfolded in a cyclone fashion in March akin to a natural disaster after a few months of somewhat back-page articles. This terrible healthcare crisis turned into an economic and financial crisis from which we are still recovering.

In 2021, we believe more standard or “known” risks are important to keep in mind, such as Fed policy reversals, a surprise/sustainable rise in inflation, oil price shocks, and/or a rise in geopolitical tensions. Throughout 2021 and beyond, we also expect questions to remain squarely on the commercial real estate workout process and the potential effect on overall activity in larger cities. Furthermore, key legislation risk is still top of mind for 2021 pending the ultimate outcome of the Senate run-offs in Georgia in early January. However, more importantly, even though we continue to receive positive vaccine news and therapeutic advancements, we believe the major risk for 2021 is any kind of sharp reversal in this dynamic that would potentially delay not just the recovery in the economy or financial markets but the healthcare recovery in our communities and society at large.

1 U.S. Census Bureau. Data as of September 2020.



What about capital market activity and potential asset allocation implications in 2021?

We see capital market activity likely transitioning in a major way as well, which can have a meaningful effect on asset allocation.

The main developments in 2021 that are core to the gateway, in our opinion, are:

• a slight increase in inflation expectations

• higher longer-dated Treasury yields, leading to steeper yield curves as rates drift higher

• a grind-it-out equity return environment that follows the square root shape trend we highlighted in The Great Convergence report from May

• the cyclically/economic sensitive (such as Financials, Materials, Industrials), small-capitalization stocks, and value (but not necessarily deep value) continue to build on the momentum from late 2020

• International equities (more specifically Emerging Markets (EMs)) are likely upgraded by the investment community, supported by, among other variables, the continued downtrend in the U.S. dollar

• stock-to-stock correlations decline, and the opportunity set in active management* widens; and

• emerging growth themes gain a strong footing and begin to separate from the “big story and promise but little-to-no-profit” areas

In terms of asset allocation, we believe the gateway year of 2021 represents a pivotal moment. This is likely to be the base year in which the long-standing standard thinking about asset allocation changes significantly. We expect the changes to include a mix shift, a more diversified rotation within equities, accelerated inclusion of developing new frontier growth themes, and a re-examining of alternative investment solutions.

For longer-term investment objectives, we believe the gateway year of 2021 is likely to include:

• higher equity exposure in order to meet long-standing return objectives

• bond portfolios built for a trend toward a pickup in long-dated yields (albeit still low ones)

• diversified mix of Growth and Value, cyclicals and high-quality core

• greater rebalancing as new cycles develop as the Fed pivots in the coming years

• inclusion of less liquid strategies in alternatives for qualified investors across asset classes

• a major increase in the inclusion of sustainable investing metrics and emerging growth themes

Investors will likely be considering moving up the risk profile spectrum in order to meet their objectives and/or liability targets. Some may decide to increase their level of accepted illiquidity in order to achieve long-term growth objectives. At the same time, we expect a new wave of investors to begin to enter the investment environment given the rising need to invest for retirement and the acceleration of stock enthusiasts born out of the pandemic.

* Active management seeks to outperform benchmarks through active investment decisions such as asset allocation and investment selection.



Moreover, we expect investment flows to increase while the overall supply of investment assets (even in the face of new offerings) declines (consolidation, mergers and acquisitions (M&A), bankruptcies, public-to-private), which could underpin above-average valuation multiples in the years ahead. A disciplined investment process focused on the intersection of investment management, planning and emerging themes should rise in importance, in our opinion. With a growing list of new investors (demand), a declining supply of available assets in general, and an investment landscape that could experience a change in the long-standing trend in yields, 2021’s gateway represents a pivotal moment in asset allocation, in our opinion.

We believe investors should re-examine their strategic and tactical asset allocation policies early in the new year in order to explore where they can take advantage of trends that we expect to build throughout 2021 and well into “The New Frontier.”

The key question for those interested in market targets for year-end 2021 is what the level of S&P 500 earnings could reach in 2022. The market looks ahead and begins to discount the following year’s fundamentals prior to the current year closing its books. If our expectations of strong profit momentum come through over the next two years, given our view of strong operating leverage in the private sector and a high-level pent-up demand in the broader economy, the likelihood of upside to the BofA Global Research S&P 500 target of 3800 for year-end 2021 could be quite high. Market sentiment seems to be a little ahead of itself as we turn the calendar, and a market exhale in Q1 is possible. We would view weakness as a buying opportunity for investors who are aligned with the base case environment of a full economic recovery in 2021 and continued strong momentum in profits in 2022 as “The New Frontier” unfolds.

In the end, for asset allocators, we expect a “grind-it-out” year in equity returns that far outpace fixed income, and what matters most is our expectation for a broad market advance relative to the narrow advances we have recently experienced, in our view. The bull market for equities continues in 2021, in our opinion, and investors should reassess their portfolio allocations early in Q1 to take advantage of this gateway year.

MACRO ENVIRONMENT

What is the CIO’s outlook for the global economy for 2021?

We believe it’s early days in the synchronized global expansion that began in the second half of 2020, as economies around the world reopened after the spring pandemic shutdown induced a very sharp, but short, economic downturn. Prior to the shutdowns, the U.S. economy was in the 11th year of the longest economic expansion ever. While there was little evidence of an imminent recession coming into 2020, there were signs that the expansion was long in the tooth. In particular, the labor market was very tight, with unemployment at the lowest levels in a half century, causing businesses difficulty finding qualified workers to fill high levels of job openings. Today, there is much higher unemployment and more churn in the labor market. Layoffs are much higher but so is job growth, as the U.S. economy restructures for a post-pandemic world.

The unexpected pandemic shutdowns caused an immediate recession, and the climb out of it has followed many of the typical dynamics seen in every business cycle. The recovery also has special features that are particular to the effect of the pandemic and the policy response to it. First, in terms of the common patterns seen in economic recoveries from recessions, financial markets and leading economic indicators have followed the usual trajectory of a new economic expansion. Stock prices have led the way, causing many to doubt that they were consistent with the poor economic data reported in the spring. As usual, however, the data have since improved, confirming the equity markets’ leading indicator properties.



The equity markets turned in the last week of March, when the first Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) was signed into law. It was the biggest fiscal response to a crisis since at least World War II, an order of magnitude larger than any fiscal government stimulus seen since then. Economists have consistently underestimated the CARES Act’s power and as a result have consistently underestimated the power of the economic rebound from the shutdown. The lagged effect of this will likely carry through next year. Coupled with the unprecedented monetary accommodation, it may propel the U.S. through 2021, with very strong growth likely to keep outstripping economists’ expectations for about 4% gross domestic product (GDP) growth, which is double their pre-pandemic view for 2021. We expect this catch-up of consensus views, which has already been going on for the past eight months, to continue well into 2021. It’s typical in the first year of recovery for the economy to outperform recession-depressed expectations. That’s been especially true in this one.

As shown in Exhibit 1, the U.S. fiscal response is the biggest in the world, more than double that of the next biggest response, which is China’s. As a result, China and the U.S. have done much better than the eurozone, for example, which is still squabbling over a fiscal response—much of which has been delayed into 2021. The decline in 2020 GDP has therefore been less in the U.S. and China as their recoveries have been quicker and more powerful. Despite further decoupling, the two main engines of this synchronized global expansion are positioned for strong growth in 2021 as the pandemic fades, helped by several new vaccines that are expected to be deployed over the next six months.

Exhibit 1: U.S. Policy Response to Pandemic Dwarfs That of Other Countries.

Debt levels and changes in leading economies

2020 Government

Debt in U.S. Dollars

(billions)

2020 Debt Increase in U.S. Dollars

(billions)

Population (millions)

Debt Increase per Capita in U.S. Dollars

Total Debt per Capita in U.S. Dollars

U.S.A. 22,210.0 4,200.0 328.2 12,797 67,672

China 9,654.80 1,659.5 1,393.0 1,191 6,931

Japan 9,005.80 719.8 126.5 5,690 71,192

France 2,917.6 339.2 66.9 5,063 43,552

Italy 2,846.4 244.3 60.3 4,048 47,157

United Kingdom 2,677.7 464.0 66.6 6,961 40,176

Germany 2,122.9 438.8 83.0 5,286 25,571

Canada 763.0 308.4 37.6 8,202 20,300

Source: GaveKal Research. Data as of December 3, 2020.

Expansionary monetary and fiscal policy are typical as governments respond to recessions and help jumpstart new expansions. What’s different this time is the magnitude of the response, especially in the U.S. The Fed was already set to ease its overly restrictive policies that constantly hindered achieving its inflation target. The timing of the pandemic thus coincided with the need for much easier monetary policy. At the same time, the pandemic broke down traditional political barriers to aggressive fiscal government stimulus. In our view, this means that 2020 is likely an inflection point for U.S. financial markets, comparable in significance to 1982, which saw the end of a several-decade rise in interest rates and inflation and the beginning of a four-decade decline in interest rates and inflation. The 2020 structural shift in fiscal and monetary policy could mark the end of the long-term disinflation trend and the beginning of a successful reflation and eventual normalization of interest rates around levels consistent with long-term inflation of 2% or more.



Another differentiating factor of the pandemic recession and recovery is the differential effect on goods versus services. Recessions traditionally are harder on goods demand than on services. Big-ticket demand for housing and auto-related goods has been very strong throughout the pandemic, while services like travel, leisure and group activities have been hit much harder and are likely to see a flood of pent-up demand unleashed as vaccines speed the normalization process. At the same time, low interest rates and favorable demographics, together with the likely permanent shift in working-from-home preferences, should keep housing strong for the years ahead, while travel and other pandemic-slammed activities add to already strong economic momentum.

Stronger growth combined with early-cycle operating leverage has already boosted U.S. domestic profits to fresh record highs. While the U.S. and China are leading out of the pandemic crisis,2 the rest of the world is following as global trade resumes and has more catch-up to do in 2021. This is another typical pattern at the beginning of global expansions when capital flows out of less risky assets into EMs and developed countries with slower, more structurally challenged economies. The U.S. has more technology-led secular growth, while the rest of the world depends more on cyclical growth, which is expected to be strong in 2021, in our view, helping foreign markets to perform better relative to the U.S. than they have over the past decade.

What is the productivity growth outlook and its implications for potential GDP growth in 2021?

Economists were baffled by the weak productivity growth of the 2011-2016 period and equally surprised by strengthening productivity growth since. Non-farm productivity growth has massively exceeded expectations to the upside this year, rising 2.9% year-over-year in Q2 and 4.1% in Q3. This comes after a gain of 1.7% in 2019 (which was close to its past 40-year average pace of 1.9%, even with the manufacturing sector in recession) and compares with a 0.7% average between 2010 and 2016 and 1.5% between 2016 and 2019.3

Expectations for persistent productivity weakness have caused a constant underestimation of U.S. potential GDP growth and an overestimation of inflation. This is one reason why the Fed has constantly undershot its inflation target. In contrast, we believe the U.S. to be embarking on a new productivity uptrend, and we continue to expect productivity growth to fluctuate around a likely 3% trend during the next few years.

Most of the forces that tend to lead productivity growth have moved in favor of a rebound in the productivity trend. These include the economic, financial, confidence, regulatory and tax backdrops, which have reversed since 2016 in favor of a stronger productivity-growth trend. Also, the dollar’s shift to one standard deviation overvaluation since late 2014 increased pressure on companies to find ways to cut costs in order to remain competitive. This process is likely to keep supporting the productivity-growth trend ahead. In addition, the age composition of the population should also work in favor of faster productivity growth over the next decade because millennials represent the biggest age cohort in U.S. history and are dominating U.S. job growth as they come of age and enter the labor market. Their depressing effect on productivity will likely ease over the next decade as they move from their low-productivity 20s to their higher-productivity 30s and 40s.

The productivity-growth pickup is boosting potential GDP growth more than is commonly appreciated. Stronger productivity bodes well for rising U.S. standards of living as well as for corporate revenue growth, margins and profits.

2 Bloomberg, Reuters. Data as of November 2020. 3 U.S. Bureau of Labor Statistics. Data as of December 2020.



EQUITIES

What is the CIO’s outlook for corporate profit margins and its role in driving earnings in 2021?

Equities are ultimately driven by earnings, and profit margins are a key input to the bottom line. While the current consensus projects S&P 500 earnings per share (EPS) to dip to $138 this year, as net margins have been dragged down to a multiyear low of 9% in Q3, expectations for earnings in 2021 have climbed to $168, and prospects for margin recovery have surfaced as economic expansion continues to progress. The U.S. Earnings Revision Ratio (ERR) has also surged to over 2.44, indicating momentum for upside surprise. We expect higher nominal GDP growth, lower interest costs, rising productivity, and a market composition shift toward asset light business models (such as Technology, Healthcare, Communications), to power profitability and earnings going forward.

Margins tend to be cyclical by nature and follow the business cycle. As the economy expands, demand and pricing power pick up, and a shift from consumer saving to spending drives corporate revenues higher. Companies that can efficiently manage their costs via operating leverage could subsequently boost their profit margins during expansions. As the new economic recovery continues and has been exceeding most expectations, the conditions for higher levels of nominal growth are ripe, especially given the unprecedented backdrop of synchronized global government stimulus. BofA Global Research projects nominal growth to exceed 6% in the U.S. next year and 7% globally.4 Given expectations for higher nominal growth, we would expect margins to similarly expand, which should help earnings to “grow into” valuations.

One catalyst for sticky margins and profitability is productivity growth, or getting more with the same or even less. While the pandemic initially curtailed the outlook for capital spending, which is a key driver of productivity, it’s begun to turn upward once again. Also, many companies have been forced to make both temporary and more permanent adjustments to their day-to-day operations and expense budgets, and accelerated the transition to digital solutions. Some industries and companies will likely see lower profit margins in the near term as they invest in e-commerce platforms, and data centers, retire legacy systems, transition to the cloud, and invest in real-time supply chains and new scalable automation and digital solutions that have upfront investment costs but that could ultimately result in higher margins once complete. Most of these adjustments and investments will likely be margin enhancing in the intermediate and long term, especially when combined with the efficiency plans many companies are undertaking that will tend to play out in the next couple of years. These plans will help drive a reduction in manual work, eliminate redundancies, and optimize office space and real estate costs. All of this leads to the aforementioned improved productivity and should drive higher levels of capital expenditures focused on technology and digital solutions as the economy transitions to “The New Frontier.” We already see examples of this across many industries, including the consumer retail, healthcare, foods, staples, energy, materials, financial and industrial industries.

A shift in the composition of equity indexes has also had a major effect on margins. The share of the S&P 500 comprising the Healthcare, Technology, and Communication Services sectors now totals 53%. These businesses tend to enjoy higher and more stable margins, in part due to achieving high operational leverage. For example, the Technology sector averaged net margins of 15.4% from 2004 through 2019, according to FactSet. Alternatively, sectors like Financials and Energy typically have lower or more volatile margins, are fixed-asset intensive, and have seen their collective market share shrink over time.

4 Nominal total reflects estimates of real GDP (4.5% in the U.S., 5.6% globally) plus CPI (1.8%, 2.6%).



Lower interest costs and taxes also provide a boost. We anticipate that rates should remain historically low, which minimizes interest costs, helping to bolster net margins especially as corporate debt has swelled to nearly $11 trillion.5 Additionally, corporate taxes have trended lower, which helps to increase after-tax profits. According to BofA Global Research, lower interest expenses added approximately 1.1% to net income margins since 2004, while lower taxes added 1.4% through 2018, the first full year following the Tax Cuts and Jobs Act of 2017 (Exhibit 2).

The trajectory for equities in 2021 and beyond is going to be dependent on the path of profit margins, as we move toward “The New Frontier.” Much work needs to be done on the road to normalization, and some industries could remain permanently challenged. However, the relative stability and potential for margin expansion could lead to upside earnings surprises as rising GDP, productivity, lower interest costs, and mix shift toward more profitable business models provide tailwinds.

Exhibit 2: S&P 500 Margins Picked Up Tailwinds over Time.

7.6%

12.4%

1.6% 0.3% 0.2% 0.5%1.1%

1.6%0.7%

0.7%

0%

2%

4%

6%

8%

10%

12%

14%

1994-2004Net Margin

COGS ex-D&A

(Decreased since 2004)

D&A(Increased

since 2004)

SG&A ex-R&D

(Increased since 2004)

R&D(Increased

since 2004)

InterestExpense


Other Expenses


Taxes(Decreased

since 2004)

2018 TaxReform

NetMargin2018

COGS = Cost of goods sold; D&A = Depreciation and amortization; SG&A = Sales, general and administrative expense; R&D = Research and development expense Source: BofA Global Research, June 8, 2020.

Why does the CIO think we are currently in a secular bull market?

We have often said that we are in a secular bull market, with the pandemic-driven exogenous bear market an interruption similar to the dynamic in 1987. As we head into 2021, with the economic recovery progressing, we believe there are three pillars emerging as a foundation for a long-term advance in U.S. equities.

An accommodative Fed amid low inflation forms one pillar of this foundation. Though investors have argued that lagged effects of the massive monetary and fiscal government stimulus could lead to an unexpected upward spiral of prices once the pandemic comes to an end and consumers fully tap into pent-up demand, there are no signs yet of runaway inflation. The core personal consumption expenditures (PCE) index has moved higher since its steep fall in April, but the inflation measure still sits well below the Fed’s 2% target at 1.4% as of October. For now, higher levels of inflation appear to be a sign that the actions taken at the start of the pandemic by the Fed are currently working to plug the hole between where GDP is versus where it could have been absent the pandemic, helping to prevent a deflationary spiral. The Fed is likely to remain accommodative given its new average inflation targeting framework that allows for inflation to run above target as a way to compensate for any periods that inflation undershoots. Still, labor market slack and rising investment in productivity-enhancing technologies should help mitigate any potential upward pressure on wages and inflation over the longer-term.

5 Board of Governors of the Federal Reserve System. Data as of December 2020.



A second pillar is innovation, which will likely accelerate, creating new business models and industries as the pandemic has compressed the time frame for trends that were set to unfold over the next several years into a few months. Think more creative destruction ahead as declining business models are being replaced with faster-growing ones, transforming the stock market in its wake. The average tenure of a company’s listing on the S&P 500 will likely shrink to just 12 years by 2027, according to Innosight’s work on corporate longevity, declining from 24 years in 2016 and 33 years in 1964.6 At this churn rate, a significant number of companies could be replaced in the S&P 500 in the next decade. Companies with declining business models tend to either shrink in market value, go out of business, be taken over to be fixed by stronger players or private equity, or be replaced by faster-growing and more digital-oriented businesses. Note, however, that these changes are natural for a free market economy and should ultimately lead to more efficient allocation of capital and greater productivity.

Third, the reshoring trend already in motion prior to the pandemic is expected to further accelerate due to the need for greater supply chain resilience, national security concerns, and lower tax and labor cost arbitrage between the U.S. and China. Reshoring efforts ultimately demand investment, with companies leaning on automation and robotics to support these production transitions. While the consumer remains the backbone of the U.S. economy, new economy capital expenditures (capex) comprising software spending, technology equipment, and research and development (R&D) should be a driving force for economic activity. It is notable that traditional capex made up of investment in structures and in industrial and transportation equipment has steadily declined as a percentage of total capex, while new economy capex spending has risen from 24% of total capex in 1980 to in excess of 50% of total capex now, according to Cornerstone Macro (Exhibit 3). More technology investment should help increase productivity, provide greater speed and efficiency to the market, and help boost profit margins, which would allow companies to further invest and support broader job growth.

Exhibit 3: The Share of New Economy Capex is on the Rise.

20

30

40

50

60

70

80

19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

20122014

20162018

2020

Old Economy (Structures, Industrial Equipment, Transportation Equipment)

New Economy (Software, Technology Equipment, R&D, Capex)

% of Total Capex

Old Economy: 49.7%

New Economy: 50.3%

Source: Cornerstone Macro. Data as of November 30, 2020. Shaded areas represent recessions.

6 Innosight, “2018 Corporate Longevity Forecast: Creative Destruction is Accelerating,” 2018.



Does the CIO believe equities are currently expensive? What are the surprise catalysts that could drive valuations for equities, both positively and negatively?

Equity prices can be highly sensitive to changes in valuation metrics. With the S&P 500 12-month forward price-to-earnings (P/E) multiple at 22x, sitting well above its historical average of roughly 16x and in the 93rd percentile, investors have questioned whether the market should be viewed as expensive.

The story on valuations, however, is changing as a new paradigm shift toward structurally higher valuation multiples unfolds as easier monetary policy leads to a low-rate environment and technological innovation holds inflation lower, putting a premium on Quality, Yield and Growth characteristics offered by the equity markets.

Beyond P/E ratios, equities remain attractive relative to bonds on various yield and cash flow measures. The dividend yield of the S&P 500 is roughly 70 basis points (bps) higher than the 10-year Treasury yield, as of December 1, 2020. The S&P 500’s Equity Risk Premium, which is the difference between the earnings-to-price ratio (inverse of the P/E) to a risk-free interest rate such as the 10-year Treasury yield, is 3.7%, which represents the 71st percentile of its 30-year historical range. Also, according to Empirical Research, U.S. companies have been effective in sustaining their free cash flows through the pandemic by pulling back on certain discretionary cash outlays, making the free cash flow yield attractive (Exhibit 4). These metrics suggest a bullish backdrop for equity investors.

Looking ahead to next year, we have identified some possible catalysts that could steer equity valuations over the medium term. Shifts that would potentially lead to further multiple expansion include:

• a sustained reversal of investor flows out of bonds and into equities and the redeployment of elevated levels of cash;

• further medical advancements that help to support reopening efforts on an accelerated timeline; and

• better-than-expected economic growth even as inflation stays low.

Stronger fund flows into equities and positive vaccine developments recently have helped to lift equity markets and improve market breadth, with 93% of the S&P 500 stocks trading above their 200-day moving average. If inflation remains at moderate levels, monetary policy should stay accommodative, helping to support accelerating economic activity globally. An upside surprise on earnings could also lead to higher valuation multiples. Improvement in the earnings picture has already started to pop up, with Global Earnings Revision Ratios (ERRs) rising in November. ERRs have improved in every region, moving above 1.0, which signaled more upgrades to earnings estimates than downgrades.

On the flip side, while not our base case, an unexpected spike in interest rates would be a negative for relative valuations, as the reversal of the current low interest rates would tighten financial conditions. From an economic recovery perspective, if the labor market improvement slows meaningfully and unemployment remains high, consumer demand would suffer, and sentiment would likely turn bearish. Finally, ongoing regulatory scrutiny on the technology and communication services industries are also worth keeping an eye on, as adverse antitrust measures and severe curtailment of their growth potential could pressure their valuations and in turn could affect the entire stock market.



Exhibit 4: Free Cash Flow Yield Relative to the 10-year Treasury Yield is Flashing a Bullish Equity Signal.

Free Cash Flow Yield for Large-cap Stocks* Less the 10-year Treasury Yield

-12

-9

-6

-3

0

3

6

Mar

-52

Jan-

54N

ov-5

5Se

p-57

Jul-5

9M

ay-6

1M

ar-6

3Ja

n-65

Nov

-66

Sep-

68Ju

l-70

May

-72

Mar

-74

Jan-

76N

ov-7

7Se

p-79

Jul-8

1M

ay-8

3M

ar-8

5Ja

n-87

Nov

-88

Sep-

90Ju

l-92

May

-94

Mar

-96

Jan-

98N

ov-9

9Se

p-01

Jul-0

3M

ay-0

5M

ar-0

7Ja

n-09

Nov

-10

Sep-

12Ju

l-14

May

-16

Mar

-18

Jan-

20

Recessions Free Cash Flow Yields <10-year U.S. Treasury Yield Current LevelDifference in percentage points

Sources: Federal Reserve Board; Corporate Reports; National Bureau of Economic Research; Empirical Research Partners Analysis. *Excludes financial, real estate investment trusts (REITs) and utilities; capitalization-weighted data. Data as of November 30, 2020. Past performance is no guarantee of future results.

What are the prospects for International equities in 2021? Is it time to consider adding International to long-term portfolios?

Over the last decade, U.S. equities have handily outperformed their International brethren. Behind the achievement, the U.S. has benefited from:

• a stronger domestic economic recovery out of the 2008-2009 Global Financial Crisis, boosting profit growth;

• the development of now dominant technology companies, underpinning corporate dynamism; and

• more proactive monetary and fiscal policies.

Then came the coronavirus pandemic, which led to cratering stock markets and a historic global recession. Equities began to recover as governments rushed in to backstop economic growth and help economic activity get restarted. More recently, encouraging news regarding the development of vaccines has fueled expectations of a path toward economic normalization in 2021. These developments have lifted stock markets from the U.S. to the EMs and Japan back above levels predating the health crisis, though Europe has lagged somewhat. Despite the rally, International equities remain historically undervalued compared to those in the U.S. (Exhibit 5). Going forward, we believe investors should consider adding to International equities in long-term multi-asset portfolios, especially in those that are substantially underweight the asset class relative to strategic weights. We see several catalysts in 2021 that can potentially help to narrow the wide performance gap of international markets.



Exhibit 5: Compared to the U.S., the Low Valuation of More Cyclically Sensitive International Market Indexes Makes Them Intriguing Candidates for Diversified Portfolios.

0.4

0.5

0.6

0.7

0.8

0.9

1.0

Rela

tive

Pric

e to

Boo

k Ra

tio

Feb-95 Oct-97 Jun-00 Feb-03 Oct-05 Jun-08 Feb-11 Oct-13 Jun-16 Feb-19

World (ex-USA) Index / USA Index

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

Apr-95

Apr-97

Apr-99

Apr-01

Apr-03

Apr-05

Apr-07

Apr-09

Apr-11

Apr-13

Apr-15

Apr-17

Apr-19

Rela

tive

Pric

e to

Boo

k Ra

tio

Emerging Markets Index / USA Index

Sources: Chief Investment Office; Bloomberg. Data as of November 27, 2020.

As the rollout of the coronavirus vaccine progresses, the release of pent-up demand and the gradual return of service-based business activity should yield a more globally synchronized and strong economic recovery next year, underpinning growth in corporate revenues and earnings (Exhibit 6). Indeed, incipient signs of this fundamental upswing can be discerned by sharply rising ERRs across all regions, which is typical in the early stages of an upturn in profits. According to BofA Global Research, historically when the ERR has been near current levels, the average return of the MSCI All Country World Index has been 7.4% over the subsequent 12 months. China has managed to contain the coronavirus better than other countries, enabling a V-shaped rebound in industrial activities, followed by a gradual comeback in consumption. While Europe’s economy has slowed recently due to the coronavirus’s resurgence, the greater use of masks, social distancing and government restrictions has led to a decline in the growth of new cases.

Exhibit 6: Global Profit Trends Are Expected to Reverse Sharply Next Year.

Earnings per share growth (%)

2018 2019 2020E 2021E

S&P 500 20.9 1.0 -14.7 21.6

MSCI Japan 6.4 -13.9 -29.4 29.0

MSCI Europe -0.1 -2.1 -27.1 30.7

MSCI Emerging Markets 1.0 -14.1 -9.6 31.4

E=Estimate. Source: FactSet. Data as of November 30, 2020. S&P 500, MSCI Europe and Emerging Markets in U.S. dollars. MSCI Japan in local currency. Short-term performance shown to illustrate more recent trend.

Also establishing a constructive backdrop for International equities is monetary and fiscal government stimulus, registering an unprecedented 30% of global GDP, according to Cornerstone Macro. In Japan, new Prime Minister Yoshihide Suga has promised to build on “Abenomics,” an economic policy platform whereby fiscal and monetary policies are coordinated. In Europe, there are signs of a bridging of the North-South divide, with the proposal of the Next Generation European Union (EU) fund, a pan-European fiscal response worth €750 billion aimed at stabilizing countries hard hit by the pandemic. Its approval by the parliaments of member states should build on confidence in a greater fiscal union and sustainability of the euro.



International equities can also inject more cyclicality into portfolios, a factor that tends to benefit during the early innings of an economic recovery. Broad indexes for Europe and Japan have higher exposures to cyclical industries compared to the U.S. According to MSCI, Financials and Industrials comprise only a 9.4% and 7.9% share of the USA index respectively. In contrast, Industrials comprise 20.6% of Japan’s index, while Financials make up 15% of Europe’s. Broad EM indexes provide significant exposure to China, Taiwan and South Korea, known for their technological prowess, which are also levered to the global trade cycle. The approval of the Regional Comprehensive Economic Partnership (RCEP) should provide a boost in trade for the region.

The potential for a decline in geopolitical risk could also benefit international equities. President-elect Joe Biden is likely to reduce trade tensions with allies such as Europe and Japan, as well as re-commit the U.S. to the global multilateral system. While the technology war with China is likely to remain in place, Biden may potentially cool heated developments on the U.S./China tariff front. Finally, our expectation of a weakening U.S. dollar should be especially beneficial for EM economies with high levels of dollar-denominated debt.

Together, these factors underpin our more constructive view on International equities for 2021. We believe investors should consider adding exposure to these regions in long-term multi-asset portfolios, particularly if they are significantly underweight relative to U.S. equities. However, we remain neutral International Developed markets due to near-term risks, such as rising coronavirus cases in Europe and Japan, which risk undermining their nascent economic recoveries. In Europe, will continue to monitor in 2021 the implementation of the region’s recovery fund, and other political risks such as elections in the Netherlands and Germany, as well as in the region of Catalonia, which may spur secessionist fears in Spain. While we expect the fundamental outlook to improve, key risks within EMs (ex-China) include lower fiscal and monetary capacity to continue to support economic recoveries in many countries, as well as weaker healthcare systems.

FIXED INCOME

What are the potential implications of monetary and fiscal policy on interest rates, the curve and fixed income assets for 2021?

Since the crisis began, market participants have doubted the efficacy of the government’s fiscal and monetary response in reversing significant economic damage. With eight months’ hindsight, the evidence is compelling: Market, economic, and sentiment data tend to confirm a strong recovery so far this year, and the targeted and large-scale government support is largely the cause. While there may be volatility and noise in high-frequency macroeconomic data through the winter, we are positioned for a broad-based recovery with continuing positive news on vaccines, and are at the beginning of a new economic cycle, in our opinion.

Economic cycles are called “cycles” for a reason; while never identical, they follow somewhat predictable patterns. One of the more consistent cycles during an economic recovery is the interest-rate cycle, since many factors affecting interest rates are directly and specifically controlled by policymakers. The Fed cuts interest rates; short-term interest rates tend to move lower faster than long-term rates; the interest rate curve—the difference between short and long rates—expands, or “steepens”; this helps encourage credit and monetary creation; economic growth and inflation follow, and rates start to rise.



We expect this pattern to continue in this cycle, with one notable difference. First, the Fed has committed to continue using its balance sheet to purchase long-term assets, mostly Treasurys and Agency Mortgage-backed Securities (MBS). Secondly, many International Developed market policy and long-term interest rates are close to zero, or even negative. The confluence of these two factors means that longer-term U.S. rates are unlikely to rise as much or as quickly in this cycle as in the past, in our opinion. Therefore, while the rate curve will likely steepen and long-term rates start to rise—consistent with past cycles—the moves are expected to be slower and more muted than in the past.

In previous rate-cutting cycles—early ‘90s, early ’00s, the Global Financial Crisis of 2008-2009—the interest-rate curve (as measured by the fed-funds-to-10-year Treasury spread) reached almost 400 bps at the beginning of each recovery (Exhibit 7). That would imply a 10-year Treasury rate of 4% currently based on history—well above its current rate of <1%. That is a bridge too far in the near term, in our opinion.

Exhibit 7: Given Fed Purchases and the Global Rate Environment, the U.S. Rate Curve is Unlikely to Steepen As Much As in Prior Cycles.

10-year Treasury Yield Minus Fed Funds Rate (basis points)

(200)

(100)

-

100

200

300

400

Source: FactSet. Data as of November 2020.

Our belief is that longer-term rates will move up only gradually in 2021. The official forecast from BofA Global Research is for 10-year rates to reach 1.35% by Q3 2021. It is possible that 10-year rates settle into the 1.5% to 2.0% range over the next 12 months plus. This would indeed lead to a steeper yield curve; however, it would likely not be even half as steep as in prior cycles.

The implication for fixed income assets is similar to prior cycles. As the economy improves, volatility decreases, and credit spreads normalize or move lower, assets with additional credit, liquidity or prepayment risk—Investment-grade corporates, municipals, MBS—should tend to outperform more rate-sensitive assets like U.S. Treasurys over longer time periods. Furthermore, given how low Treasury rates are right now, the yield ratio of some of these assets relative to Treasurys makes them even more attractive, in our opinion. For example, the Treasury market currently yields 0.56%, while the Investment-grade corporate market yields 1.80%.7 This means an investor could earn more than 3x the yield on Treasurys without taking significant credit risk, as Investment-grade corporates average only 0.05% in credit losses per year.8 Maintaining some high-quality Treasury exposure while over-emphasizing relatively low-risk high-quality fixed income assets that offer additional yield may be prudent, in our opinion.7 Bloomberg Barclays Indices. Data as of November 30, 2020. 8 Moody’s Investor Service, “2019 Annual Default Study,” February 2020.



Could the coronavirus have a lasting effect on the muni market, and what might we expect in 2021 and beyond?

We believe that munis remain generally high-quality investments and an appropriate asset class for conservative investors. Certainly, the coronavirus adversely affected credit for many municipal bonds in 2020, and we believe conditions will remain challenging in the first half of 2021. However, with widespread dissemination of effective vaccines likely only a few months away, we believe municipal credit should stabilize and then improve by the end of 2021.

For most states and local governments, income taxes and sales taxes have been lower, while health and social service expenses have been higher. Certain municipal revenue bond sectors have also been affected, notably airports, transit, hotel occupancy tax bonds, higher education, and adult living facilities. When the coronavirus pandemic first hit the U.S., the muni market saw significant disruption, with record outflows from muni bond funds and a spike in yields. However, the effect has turned out to be less severe than initially feared because, after over 10 years of economic expansion, most issuers had built up significant reserves they were able to tap, and they were also able to make adjustments to their budgets through a combination of tax hikes, expense reductions, and deficit borrowing. The federal government also responded aggressively with fiscal and monetary stimulus: The CARES Act gave over $300 billion to municipal issuers, while the Fed’s newly created Municipal Liquidity Facility helped issuers that were unable to access the capital markets. As a result, market confidence returned, and high-quality municipal bond valuations have now recovered to pre-pandemic levels.

The amount and timing of further government stimulus is uncertain. We expect Congress to provide some additional aid to states and local governments, either in the “lame duck” session or early next year. The Fed’s Municipal Liquidity Facility is scheduled to sunset at the end of 2020, but it has been little used to date, and may not need to be restored next year. Looking forward, we expect state and local government tax revenues to improve in calendar year 2021, as business shutdowns will likely be less stringent than they were in Q2 2020, and once most of the population has been vaccinated, we expect tax revenues to further normalize. Airport and transit volume may take somewhat longer to return to pre-pandemic levels, but for purposes of bondholder security, we believe revenues and reserves should be sufficient to cover debt service and operations in most cases. Higher education and adult living facility revenues should also mostly recover. Therefore, we expect few, if any, municipal bonds that were Investment Grade heading into the coronavirus crisis to default.

ALTERNATIVE INVESTMENTS

How should qualified investors think about allocations to alternative investments in 2021?

We believe the upcoming year should present a number of compelling opportunities for qualified investors looking to allocate to alternative investments (AI). What makes this environment appealing to us is a positive set-up across the AI spectrum, in directional and non-directional strategies and in cyclical and non-cyclical strategies, alike. Here are some thoughts as we head into the new year.

We currently see a favorable opportunity set for select hedge fund strategies given the effect of the pandemic on a wide range of assets. Recent positive vaccine news, coming on the heels of an unprecedented policy response, has significantly improved the macro backdrop. However, it is becoming clear to us that not all sectors stand to benefit in the same way, and with some “winners and losers” beginning to emerge, we think correlations between stocks could continue to decrease while dispersion increases. In this environment, skilled stock pickers should do well, and, accordingly, we believe



qualified investors should look to equity long/short and equity market-neutral strategies as a means of generating differentiated equity returns that place an emphasis on alpha through active management. For investors seeking diversified return streams, global macro strategies, which are currently enjoying conditions that are better than they’ve been in years, may also help provide solid returns given the current landscape where macroeconomic forces are increasingly dictating price action across all parts of the investment spectrum—stocks, bonds, currencies and commodities.

M&A activity rebounded in the third quarter9 with consolidation taking place in a number of different sectors, likely the result of the pandemic and its effect on everything from commerce to healthcare to energy. In light of the dislocations caused by the coronavirus, we expect that savvy private equity managers will continue to deploy dry powder to buyout and distressed areas of the market, via direct and through secondary investments. Within the broad private equity universe, we currently favor special-situation strategies (e.g., short-term financing, balance sheet repair, turnarounds) that could benefit from pockets of stress resulting from the pandemic and from secular shifts across sectors due to disruptive technologies. Private credit strategies also appear well positioned should M&A activity remain buoyant, since creative financing solutions will likely be sought after to help support increased deal volume. These strategies may be of interest to qualified investors seeking enhanced yield that can complement traditional fixed income investments. As per usual, and even more important in markets like these, investors should plan a disciplined, multiyear commitment strategy that builds portfolio diversity among different managers, styles, geographies and vintages.

The pandemic has had a profound effect on the commercial real estate (CRE) market. In the near term, we think conditions will be closely tied to the duration and severity of the pandemic and could continue to weigh on pricing, volume and cash flows in certain parts of the core real estate market (hospitality, retail, office). Prior to this “pause,” the supply and demand for rentable space were relatively balanced across the country, with a few property types and market exceptions, such as regional malls and power centers in the retail category, and in some multifamily and central business district office markets. For prospective qualified investors, we would place emphasis on direct investments in well-located properties in strong regions of the country that will help exhibit attractive rent-roll and cash-flow characteristics and have the potential to bridge into the next cycle, helping to provide a long-term hedge against potential inflation. Additionally, given the increasing importance of e-commerce to consumers’ everyday lives, we believe the Industrial sector (warehouses, data centers, etc.) will likely be an area of growth for the foreseeable future as companies compete for a position in the on-demand economy. Looking out further, there is a case to be made for adaptive reuse in certain parts of the CRE market. This strategy, which is primarily the domain of opportunistic/value-add managers, involves converting non-producing assets into performing properties. In today’s environment, that could mean converting retail, office, or mall properties into residential, medical, or fulfillment centers.

The strategies within the alternative asset class offer potential benefits to qualified investors, whether through alternative sources of beta or through alpha from active management, complexity and illiquidity. Put together in a diversified fashion, strategic allocations to AI may help improve a portfolio’s risk-adjusted return. When deployed in a targeted fashion, allocations to AI can help investors achieve specific objectives (e.g., greater total returns, enhanced yield, and/or market exposure management). Targeted allocations to AI may also be used to tactically gain exposure to compelling areas of the market (as discussed above). As we head into 2021, we believe qualified investors should take time to re-examine their allocations to this versatile asset class, particularly in light of a much-improved opportunity set that extends beyond the boundaries of traditional investments.

9 Bloomberg, “YTD global M&A volume sits at $1.7 trillion,” November 30, 2020.



MARKET STRATEGY

How does the CIO see the outlook for China for next year? Are international trade frictions likely to continue as the U.S. transitions to a new administration in 2021?

China has been among the markets most resilient to the coronavirus crisis, and is expected to be one of only a handful of major economies to register an increase in real GDP for the full year of 2020. Growth is forecast by the International Monetary Fund (IMF) to rebound with the rest of the world in 2021 as the global economy continues to gradually emerge from the pandemic. But China’s growth rate is thereafter expected to resume its now decade-long moderation, with the IMF projecting a deceleration in real GDP to under 6.0% from 2022.

As we have discussed previously, this downtrend in growth nonetheless remains consistent with other economies that have moved up toward higher income levels in the past and should help to preserve longer-term economic stability. But more important for investors will be the composition of China’s future growth, and the latest Five-Year Plan for 2021-2025 outlined in Beijing this past October was instructive in this regard. Further details of the plan are expected to be released in March 2021, but China’s growth strategy over the medium term will likely continue to place an emphasis on increasing domestic demand, promoting green technology, and advancing local innovation in high-end manufacturing and the digital economy. Expansion in these areas will help be a primary driver of China’s prospective growth and should remain a support for key related sectors that have been outperformers over the course of this year such as Information Technology and Consumer Discretionary.

China’s growing economic size and improving technological capacity are, however, also likely to remain a source of friction in global trade and investment relations. Trade tensions with China have been a defining characteristic of U.S. foreign policy under the Trump administration. But even as the U.S. transitions to an incoming Biden administration, investors should not expect a return to the pre-2016 bilateral relationship, particularly as the gap in size between the two economies (which has closed by more than 20% over the course of this past presidential term) narrows further (Exhibit 8).

Exhibit 8: China Frictions with the U.S. are Likely to Persist as the Gap in Economic Size Narrows.

2000 2005 2010 2015 2020 E 20250

5

10

15

20

25

China

U.S.

Nominal gross domestic product$ (trillion)

IMF

E

E=Estimate. Source: International Monetary Fund. Data as of December 4, 2020.



The Biden administration may yet take a more coordinated approach that does less to undermine bilateral China-U.S. trade and investment. It is unlikely for example to pursue unilateral action on tariffs or to target individual companies for divestment or restricted access to U.S. technology and components. But it may still aim to balance these domestic business interests against national security in areas such as intellectual property and data protection, supply chain resilience and labor concerns, with differences remaining over China’s adherence to international trade and investment rules, state subsidies and forced technology transfer. This suggests that while the U.S. approach may become more multilateral, existing restrictions are unlikely to be reversed without Chinese concessions. As we have also seen over the course of 2020, pressure is also likely to continue from allied countries such as Japan, the U.K. and Australia, which alongside the U.S. have placed bans on the installation of Chinese equipment in their local telecom networks.

Though we expect a more multilateral foreign policy from the incoming U.S. government, and we still expect the digital economy to expand in both China and the rest of the world, crossborder trade and investment frictions are therefore likely to persist. This will likely remain a key risk for investors to watch in 2021 and beyond.

How are the 2020 U.S. election results likely to shape the outlook for markets in 2021?

Following the U.S. presidential election in November, a divided government with a Democratic House and Republican Senate now looks like the most probable outcome in 2021. Historically, divided government has typically been considered the best configuration for market returns, as it generally leads investors to expect less interference from changes in economic policy and therefore a greater degree of business certainty. But support for this view has not been conclusive in practice. Indeed, over the 18 presidential cycles since World War II, the weakest equity performance has in fact occurred under a divided government with returns averaging just 8.6% under a Republican president and Democratic Congress. The number of years spent under each combination has of course varied, but party splits have not necessarily always produced the strongest returns. The clearer pattern from post-war electoral cycles is that the third year has been by far the strongest, followed by the first (Exhibit 9). Each individual cycle is different, and the coronavirus crisis has of course been the dominant market driver in the final year of this past four-year term. But these historical patterns tend to nonetheless be worth keeping in mind as we start the next presidential cycle in 2021.



Exhibit 9: Market Returns and Historical U.S. Election Cycles Since 1945.

Government Configuration * S&P 500 total return*

President/House/Senate Number of years Average Maximum Minimum

D/D/D 22 14.8% 36.3% -10.0%

R/R/R 6 18.6% 52.3% -0.9%

D/R/R 10 15.9% 37.6% -9.1%

D/R/D 4 16.1% 32.4% 2.1%

R/R/D 2 -17.0% -11.9% -22.1%

R/D/D 22 8.6% 43.1% -37.0%

R/D/R 6 16.0% 31.7% -4.9%

S&P 500 Return During Post-war Election CyclesAverage total return*

11.7%9.7%

19.1%

10.0%

0%

5%

10%

15%

20%

Year 1 Year 2 Year 3 Year 4

*For presidential election cycles from 1945 to 2016. Sources: Bloomberg; House.gov; Senate.gov; Chief Investment Office. Data as of 2020. Past performance is no guarantee of future results.

Our principal view remains that progress on economic reopening, the pace of real activity, growth in corporate earnings, and the outlook for monetary policy and fiscal policy will ultimately be the most important drivers of market direction. But the immediate post-election equity market rally, in our view, owed much to the pricing out of policy risk under alternative government configurations.

Tax increases that were expected both for many individuals and corporations under full Democratic control now appear far less likely. And though tax hikes may yet be attempted later in the new administration as the focus shifts away from pandemic recovery, any such proposals are likely to be resisted by a Republican Senate.

Similarly, the likelihood of major new regulatory measures for the corporate sector also seems lower than would have been the case under complete Democratic leadership. Information technology in particular now accounts for close to 40% of S&P 500 market capitalization when broadly defined to include interactive media and internet retail. And narrower prospects for major rule changes in areas such as data privacy, antitrust and content liability should be an ongoing support for both the discrete sector and the broad market.

The Democratic leadership in the White House alongside the Democratic House is also likely to favor higher levels of discretionary government spending than under the previous administration. This may mean more fiscal outlays in areas such as transportation, communication and clean energy infrastructure. But a divided Congress should make large-scale spending increases unlikely, particularly relative to pre-election Democratic proposals.



Is there a way to increase yield in a low- or no-yield environment, and what are the potential risks in doing so?

In our view, investors should consider multiple sources of portfolio income: bond coupons, equity dividends and even alternative assets. Individually, each source may offer some degree of cash flow and/or potential opportunity for capital appreciation, and poses some risks from liquidity, volatility and growth. For example, in today’s low-yield environment, investors relying excessively on cash flows are squeezing their bond portfolios harder than ever for that last bit of current income, and as a result are venturing into riskier areas they normally might not consider. A diversified approach can help mitigate some of these risks.

Government bonds (such as U.S. Treasurys), higher-quality Investment-grade corporate bonds and municipal bonds may be seen as relatively lower-risk assets for income generation. High-quality dividend-paying and dividend-growing equities are higher on the risk spectrum. Further out on the risk spectrum are certain higher dividend-paying equities, high yield bonds, master limited partnerships, and real estate investment trusts (REITs). Finally, for qualified investors who can assume illiquidity risk, alternative assets like private credit and private real estate are options that can also help to diversify overall portfolio risk. In the post-coronavirus environment, investors should be aware to a higher degree of where their portfolio income is coming from.

Fixed Income Yield/Risk Trade-offs

Aggressive monetary and fiscal government stimulus in response to the coronavirus pandemic have moved global interest rates to historic lows. The U.S. 10-year Treasury yield hit an all-time low of 0.51% in early August, dragging municipal and corporate bond yields down with it (Exhibit 10). Real Treasury rates (adjusted for inflation) are now negative. This puts the yield-seeking investor in a bind, and looking for ways in which to increase the income generated from fixed income portfolios.

Exhibit 10: In Dropping to an All-time Low in August, the 10-year Treasury Yield Has Dragged Down Other Rates.

0

2

4

6

8

10

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Dec-13

Dec-14

Dec-15

Dec-16

Dec-17

Dec-18

Dec-19

Dec-20

Percent

Municipal Bond - Yield to Worst

U.S. Corporate Investment Grade - Yield to Worst

U.S. Treasury - Yield to Worst

Source: Bloomberg. Data as of December 4, 2020. Short term performance shown to illustrate more recent trend.

There is no secret recipe or magic bullet to boosting yields in fixed income portfolios. Higher yields mean higher risk in some form. This means adding credit risk, maturity/duration risk, or structure risk (bonds with variable cash flows). Given the current market environment, taking on some of these risks would be appropriate while others would not. Adding marginal credit risk to Investment-grade portfolios is one method investors should consider. Yield pickups in adding select BBB-rated corporate issuers and A-rated municipal issuers is still relatively attractive over higher-quality bonds. However, in doing so, proper credit analysis and diversification remains paramount. We would not consider adding to high yield bonds at this point, as valuations are currently quite rich.



Nor would we consider adding duration or maturity to portfolios in an attempt to find marginal yield. While interest rate curves are steeper than they have been in the recent past, we expect them to gradually move higher. Higher interest rates have a negative price effect on bond portfolios and could lead to negative total returns.

Finally, adding structured bonds to portfolios by the use of MBS can potentially add some yield. The additional yield these bonds offer is attractive, and they are an asset class that the Fed is currently buying at the rate of $40 billion a month. We would not consider adding other structured bonds such as Treasury Inflation-Protected Securities (TIPS), callable bonds or other cash flow variable issues, as currently investors are not being paid adequately for the risks taken.

Equities Yield/Risk Trade-offs

For income-seeking investors with the flexibility and higher risk tolerance to move lower in the corporate capital structure, one option to consider is to increase equity exposure and add stocks, managed solutions and exchange traded funds (ETFs) with attractive dividend yields to the portfolio mix. However, it is not as simple as adding the highest-yielding stocks because not all high-dividend-yield stocks are created equal. There are significant risks with chasing higher dividend yields, and often the most attractive dividend yields are sending a warning sign and are “too good to be true.” In other words, stocks with very high dividend yields often have structural or financial concerns that drive the stock prices lower and therefore dividend yields higher. A potential mistake investors can make when adding yield to equity portfolios is to buy the highest dividend yields when over the intermediate and longer term, buying the high dividend growers can potentially drive higher risk-adjusted returns while simultaneously increasing the amount of dividend income earned over time. This is why the fundamental analysis of stocks is an extremely important part of equity portfolio management.

Taking a look at dividend yields across the S&P 500 index, we find that 10 out of the 11 equity sectors currently deliver higher dividend yields than the recent 0.90% yield on the U.S. 10-year Treasury bond. Furthermore, even with equities trading near their recent highs, five of the sectors yield over 2%, as do 219 individual stocks in the S&P 500. This dynamic could help drive higher equity exposure as investors find attractive dividend yields and dividend income growth in equities. To help reduce risk in portfolios, investors should be selective because there have been many examples of very attractive-looking and very high dividend yields where eventually the dividends were partially or completely cut. These stocks often trade at very cheap valuations and seemingly have very attractive dividend yields, but are really value traps and can hurt portfolio performance. Therefore, the optimal balance within equities for adding yield is to increase exposure to high-quality companies with solid free cash flow, strong balance sheets, and a track record of growing dividends.

What could a change of administration mean for sustainable and impact investing?

Investor demand has been met with supply, with more asset managers incorporating environmental, social and governance (ESG) considerations into investment decisions than ever before.10 Why? The global health crisis, coupled with movements for social equality, expanded the focus beyond shareholders to all stakeholders, while the urgency to address climate risks heightened—propelling forward a movement that was already firmly underway. As we enter 2021, with a new administration, we expect this momentum to continue with a tailwind at its back, presenting opportunities for sustainable investing and an acceleration in thematic trends.

10 $1 in $3 of professionally managed assets in the United States follows analysis and/or strategies considering ESG criteria. Source: “US SIF Report on US Sustainable and Impact Investing Trends 2020,” November 16, 2020.



Come 2021, we anticipate a pivot to an environment more supportive toward sustainable investing. At a domestic level, it remains to be seen how the incoming administration may address the recently finalized Department of Labor (DOL) Financial Factors in Selecting Plan Investments regulation, requiring fiduciaries to select investment strategies based solely on how they will affect the plan’s performance goals, and its effect on ESG investing in benefits plans. The Securities and Exchange Commission (SEC) may take steps towards mandating public company disclosure on financially material ESG risks. This would buoy corporate-led efforts, such as the work of the International Business Council of the World Economic Forum, for a convergence of disclosures. Investors have signaled they would welcome a standardization of ESG disclosures, which would bring transparency along with consistent and comparable data, facilitating their investment decision-making by empowering analysis of rates of change and progress over time on sustainability metrics.

On the international stage, the U.S. has the opportunity to play catch-up following advancements in regulations overseas, notably with the EU sustainable finance taxonomy regulation. President-elect Biden has acknowledged his intention to cooperate with the international community, committing to rejoining the Paris Agreement and adopting a target of net zero emissions by 2050. The pursuit of emissions reductions could play out in trade policy with an international price on carbon and a renewed focus on infrastructure investments, such as a hike in investment in renewables and electric vehicles, creating additional opportunities for sustainable investing. The ripple effect of an acceleration to a low-carbon economy could also present opportunities for green investments, while posing risks to the highest carbon emitters, according to the CEO of the Principles for Responsible Investing (PRI).11 Social issues will remain a top priority for companies and countries in a post-coronavirus world, with employee health (safety precautions, medical benefits, paid leave), along with diversity and inclusivity commitments commanding investor focus.

Societal trends and imperatives for corporates in the U.S. have lent tailwinds to sustainable investments this year which we expect to continue. Demographics are also supportive, as millennial and gen Z investors enter their prime investment years. As a result, we expect continued demand for and availability of more sustainable investment strategies, which in our view may offer a competitive risk adjusted return profile within a traditional asset allocation framework.

For investors, we believe ESG is additive to the investment process, providing investors a set of additional factors to help identify market risks and potential opportunities. Portfolio strategy in the coming years should allocate more capital to assets backed or underpinned by high sustainability, in our view. Moreover, structural dynamics like rising political pressure, regulatory change and technological advances are additional planks to sustainable investing and more capital reallocation. Doing well and good have become strategic priorities of many firms and the asset managers that invest in them. Those firms that are the most transparent about their goals, and are better at execution, will likely reward investors over the long-term. The increased adoption of ESG into investment processes and the flow of capital oriented toward the United Nations Sustainable Development Goals (SDG)12 should help accelerate existing thematic trends and create challenges for lagging companies and countries.

11 Source: UNPRI, November 7, 2020. 12 Source: United Nations Division for Sustainable Development Goals, December 2019.


GlossaryActive Management refers to an investment strategy that involves ongoing buying and selling activity by the investor.

Alpha is the excess return of an investment relative to the return of a benchmark index.

Beta is a measure of the volatility, or systematic risk, of a security or portfolio in comparison to the market as a whole.

An earnings revision ratio (ERR) is calculated by taking the difference between the number of analyst upgrades and analyst downgrades, divided by the total number of analyst revisions on a monthly basis. An earnings revision ratio above zero means that there were more upgrade revisions than downgrade revisions.

Municipal Liquidity Facility: The Municipal Liquidity Facility is an initiative by the Federal Reserve to provide up to $500 billion of credit to state and local governments that have seen their revenues collapse during the COVID-19 crisis.

Standard deviation is a measure of the amount of variation or dispersion of a set of values. A low standard deviation indicates that the values tend to be close to the mean of the set, while a high standard deviation indicates that the values are spread out over a wider range.

Index DefinitionsSecurities indexes assume reinvestment of all distributions and interest payments. Indexes are unmanaged and do not take into account fees or expenses. It is not possible to invest directly in an index.

Indexes are all based in dollars.

The MSCI All Country World Index (ACWI) is stock index designed to provide a broad measure of global equity market performance.

The MSCI Emerging Markets Index captures large and mid cap representation across 26 Emerging Markets (EM) countries.

The MSCI Europe Index captures large and mid cap representation across 15 developed markets countries in Europe.

The MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese market.

The MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the U.S. market. With 619 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the U.S.

The MSCI World ex-USA Index captures the capitalization of large- and mid-sized companies across 22 of 23 developed market countries.

Personal consumption expenditures (PCEs) are imputed household expenditures defined for a period of time. Personal consumption expenditures support the reporting of the PCE Price Index, which measures price changes in consumer goods and services exchanged in the U.S. economy.

The S&P 500 includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Although the index focuses on the large-cap segment of the market, with approximately 75% coverage of U.S. equities, it is also a proxy for the total U.S. stock market.


Important DisclosuresOpinions and market data are current as of December 4, 2020 unless otherwise specified.

This material does not take into account a client’s particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security or investment strategy. Merrill offers a broad range of brokerage, investment advisory (including financial planning) and other services. There are important differences between brokerage and investment advisory services, including the type of advice and assistance provided, the fees charged, and the rights and obligations of the parties. It is important to understand the differences, particularly when determining which service or services to select. For more information about these services and their differences, speak with your Merrill financial advisor.

The Chief Investment Office (CIO) provides thought leadership on wealth management, investment strategy and global markets; portfolio management solutions; due diligence; and solutions oversight and data analytics. CIO viewpoints are developed for Bank of America Private Bank, a division of Bank of America, N.A., (“Bank of America”) and Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S” or “Merrill”), a registered broker-dealer, registered investment adviser and a wholly owned subsidiary of BofA Corp. This information should not be construed as investment advice and is subject to change. It is provided for informational purposes only and is not intended to be either a specific offer by Bank of America, Merrill or any affiliate to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available.

The Global Wealth & Investment Management Investment Strategy Committee (GWIM ISC) is responsible for developing and coordinating recommendations for short-term and long-term investment strategy and market views encompassing markets, economic indicators, asset classes and other market-related projections affecting GWIM.

BofA Global Research is research produced by BofA Securities, Inc. (“BofAS”) and/or one or more of its affiliates. BofAS is a registered broker-dealer, Member SIPC, and wholly owned subsidiary of Bank of America Corporation.

Bank of America, Merrill, their affiliates, and advisors do not provide legal, tax, or accounting advice. Clients should consult their legal and/or tax advisors before making any financial decisions.

Investing involves risk, including the possible loss of principal. Past performance is no guarantee of future results.

All recommendations must be considered in the context of an individual investor’s goals, time horizon, liquidity needs and risk tolerance. Not all recommendations will be in the best interest of all investors. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Investments have varying degrees of risk. Some of the risks involved with equity securities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Small cap and mid cap companies pose special risks, including possible illiquidity and greater price volatility than funds consisting of larger, more established companies. Bonds are subject to interest rate, inflation and credit risks. Municipal securities can be significantly affected by political changes as well as uncertainties in the municipal market related to taxation, legislative changes, or the rights of municipal security holders. Income from investing in municipal bonds is generally exempt from federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the Federal Alternative Minimum Tax. Investing in lower-grade debt securities (“junk” bonds) may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Treasury bills are less volatile than longer-term fixed income securities and are guaranteed as to timely payment of principal and interest by the U.S. government. Mortgage-backed securities are subject to credit risk and the risk that the mortgages will be prepaid, so that portfolio management may be faced with replenishing the portfolio in a possibly disadvantageous interest rate environment. Investments in foreign securities (including ADRs) involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risk related to renting properties, such as rental defaults. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.

Investing directly in Master Limited Partnerships, foreign equities, commodities or other investment strategies discussed in this document, may not be available to, or appropriate for, clients who receive this document. However, these investments may exist as part of an underlying investment strategy within exchange-traded funds and mutual funds.

Nonfinancial assets, such as closely-held businesses, real estate, oil, gas and mineral properties, and timber, farm and ranch land, are complex in nature and involve risks including total loss of value. Special risk considerations include natural events (for example, earthquakes or fires), complex tax considerations, and lack of liquidity. Nonfinancial assets are not suitable for all investors. Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations and before changing or implementing any financial, tax, or estate planning strategy.

Impact investing and/or Environmental, Social and Governance (ESG) managers may take into consideration factors beyond traditional financial information to select securities, which could result in relative investment performance deviating from other strategies or broad market benchmarks, depending on whether such sectors or investments are in or out of favor in the market. Further, ESG strategies may rely on certain values based criteria to eliminate exposures found in similar strategies or broad market benchmarks, which could also result in relative investment performance deviating.

Alternative investments such as derivatives, hedge funds, private equity funds and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk.

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