Financial markets in 2021: Recovery to a new normal?

• Author: Bonser-Neal, Catherine

Last year's financial forecast for 2020 focused on the likely effects of trade policy uncertainty and weak business investment, but the world changed completely following the World Health Organization's Jan. 5, 2020, announcement of a "pneumonia of unknown causes" in China. (1) As reports of the global spread of the new COVID-19 virus increased over the next six weeks, financial markets began to price in expectations of a pandemic and its economic consequences. Between mid-February and the mid-March beginning of government-imposed restrictions on mobility and business activity, the S&P 500 index fell by over 30%, the U.S. 10-year Treasury yield fell below 1%, and measures of volatility reached levels not seen since the global financial crisis. Yet, despite a historic drop in employment and economic activity, the S&P 500 index began to reverse course in late March, and by September had reached a new high. What do these financial market trends from 2020 suggest for 2021?

As we look to 2021, we must first understand three unusual factors dominating financial markets in 2020:

1. Differential sector impacts of the COVID-19 pandemic

   Stock prices reflect a stream of expected future earnings discounted by a factor reflecting the risk of those earnings, and so they represent a forecast of future company performance. However, a closer examination of stock index trends reveals a tale of two markets: one based upon firms which are positioned to use technology and communication platforms to grow their business in the midst of pandemic restrictions and changes in customer behavior, and one based on firms challenged in adapting to the new environment. Information technology and communication services sectors now carry nearly a 40% weight in the S&P 500 index, so changes in the values of companies in these sectors have a large influence on the overall market return. (2)

   Furthermore, Figure 1 shows that just five stocks--Apple, Microsoft, Amazon, Facebook and Alphabet (Google)--represent nearly 25% of the S&P 500's value and have dominated S&P 500 index gains in 2020. In fact, although the S&P 500 gained over 1% between January and the end of October, absent these five stocks the S&P 500 index would have actually fallen by over 8%.

   Figure 1: Percent change in S&P 500 vs. weighted percent price changes of five largest companies (Apple, Microsoft, Amazon, Facebook, Alphabet), January to October 2020 Market capitalization weightedcahnge (%) Five largest companies 9.9% S&P 500 1.2% S&P 5D0 excluding the five -8.7% largest companies Source: Price data for the five stocks and the S&P 500 were obtained from Yahoo Finance, https://finance.yahoo.com/, accessed on Nov. 1, 2020. Market weights for Apple, Microsoft, Amazon, Facebook and Alphabet as of Oct. 30, 2020, were obtained from the SPY ETF, which tracks the S&P 500. The calculation was based upon these weights and the percentage changes in the adjusted stock prices from Jan. 2 to Oct. 30, 2020. Note: Table made from bar graph. Differences in company performance this year are also highlighted in Figure 2, which shows the Russell 2000 index of smaller U.S. firms down by 7% at the end of October relative to the start of 2020, compared with the technology-heavy Nasdaq composite index's 20% gain over the same period.

2. Extraordinary monetary and fiscal stimulus measures

   In response to heightened financial market stress and concerns about the lockdown's impact on business and household incomes, policymakers quickly assembled a series of financial support measures in March. The Federal Reserve slashed its federal funds rate target to near 0%, and on March 23 announced that it would begin significant asset purchases and create credit facilities to support the flow of credit and smooth market functioning. (3) The result was the Federal Reserve's purchase of nearly $3 trillion in assets by the end of May. This amount is more than double the amount purchased during the height of the 2008 financial crisis, and it represents a 70% expansion of the Federal Reserve's asset holdings. (4)

   Another notable feature of this...