Investment Commentary, Research and Thought Leadership

Q4 2020

Q4 2020

Kai W. Hong, CFA
Managing Partner & Chief Investment Strategist

In an incredible end to an unforgettable year, markets rocketed upward for one of the strongest quarterly returns in history.  This was despite moderating macro conditions and a significant surge in the coronavirus pandemic.  More than 90 million people had been infected with over 2 million deaths globally which resulted in new rounds of lockdowns and other restrictions.  However, the approval of a group of vaccines, highly accommodative monetary policy, and the expectation for divided government in the US (more stimulus, fewer tax changes) further supported investor optimism.  The passage of a second fiscal stimulus package in the US was the icing on the risk-on cake.

The Russell 3000 Index finished the quarter with a return of +14.7%, which was over half of the total return of +20.9% for the full year.  Leadership came from the most volatile and highly leveraged names with cash flow negative companies doing particularly well.  Large cap stocks continued their strong performance as the Russell 1000 Index returned +13.7%.  However, the real action was with small cap stocks which surged to their best quarterly gain ever as the Russell 2000 Index returned +31.4%!  International markets also rallied strongly with emerging markets leading the way.  The developed market MSCI World ex USA Index returned +15.9% while the developing market MSCI Emerging Markets Index returned +19.7%.  An incremental recovery in US 10Y yields dampened fixed income returns, but credit remained a bright spot.  The Bloomberg Barclays US Aggregate Index returned +0.7% while the Corporate High Yield Aggregate returned +6.5%.  Performance in non-US fixed income was more robust as continuing US dollar weakness helped the Global Aggregate ex-US Index return +5.1% and the JPM EM Bond Index return +5.8%.

At the Sector level in US equities, the rally was led by the cyclical sectors of Energy (+29.3%), Financials (+24.8%), Industrials (+18.2%), and Materials (+17.4%).  Every sector posted positive returns for the quarter as investor optimism seemed to know no bounds.  Even the sectors that lagged, Consumer Staples (+7.1%) and Utilities (+7.8%), posted perfectly respectable performance.  Outside of the US, Technology (+24.7%) continued its leadership with Financials (+24.4%) and Consumer Discretionary (+23.7%) also strongly positive.  As in the US, all sectors were positive with Health Care (+6.4%) and Consumer Staples (+8.4%) the only ones returning less than +10%.

In a testament to the world-wide scope of the quarter’s rally, all markets save Egypt (-2.4%) were positive for the quarter.  A diverse group of countries led performance with Colombia (+47.5%), Austria (+38.7%), and Hungary (+37.7%) among a set of ten countries with greater than 30% returns.  Outside of the aforementioned Egypt, Kuwait (+1.8%), Qatar (+2.2%), and Saudi Arabia (+6.5%) were relative laggards.  Among the major markets, the United Kingdom (+18.3%) outperformed while Japan (+14.1%) and China (+11.3%) underperformed.

Within core US fixed income markets, all of the main sectors outside of Treasuries (-0.8%) were positive, but performance was strongest in Corporate Investment Grade (+3.1%) and CMBS (+1.1%).  The other securitized sectors of ABS (+0.4%) and MBS (+0.2%) produced more modest returns.  Outside of the core sectors, US High Yield (+6.5%) and Leveraged Loans (+3.8%) continued their strong recoveries from the sharp declines of the first quarter with Municipals (+1.8%) and Inflation-Linked Treasuries (+1.5%) also positive.  Emerging market debt also benefited from robust sentiment and, in a strong reversal from the prior quarter, the Government sector (+9.6%) led the way with returns in Corporates (+4.4%) more modest.

Despite the high absolute magnitude of returns, overall market volatility settled at levels only somewhat higher than historical averages.  Trade volumes were higher than average, likely supported by the continuing surge of retail investors, and market breadth was broadly positive.  At the factor level, Smaller Size was dramatically positive, recovering all of the underperformance of the prior quarters.  Value and Yield were also positive.  Stability was dramatically negative as the quarter favored cyclical recovery plays, and short-term reversion led to negative results in Momentum and Quality. With the move of market leadership away from mega cap growth, equal-weighted portfolios meaningfully outperformed market cap-weighted portfolios.