The COVID-19 pandemic not only reshaped our daily lives last year, it created an unprecedented shape to the market, one in which stocks experienced their fastest and steepest bear market decline on record, followed by a historically quick recovery to new highs. Economic, political and social conditions all entered uncharted territory in 2020.

While turning the page on the calendar doesn't mean an equally immediate change in investment conditions, we do think 2021 will bring a new backdrop against which markets will progress. Here are four of our broad views for the year ahead:

1. The economy grows gradually amid a transition from reopening to a new normal

  • We think the introduction of a vaccine in 2021 will be a necessary and key element in shifting from reopening-driven progress to a more normal and persistent level of GDP growth. This will include activity returning in the most affected industries such as travel, entertainment and leisure, which play an important role in our consumer spending-led economy.
  • Consumers will be the driving force in the comeback. We expect further improvement in labor market conditions, including a gradual drop in unemployment. However, we suspect it will take longer to return to or near pre-pandemic levels given the damage done to small businesses, shifts to virtual work arrangements as well as the expanded use of technology and automation.
  • Following the initial rebound in GDP as portions of the economy reopened in the second half of 2020, we expect growth through 2021 to be more modest, if not choppy. We think 2%-plus GDP growth (consistent with pre-pandemic growth trends) can be achieved as activity and behaviors normalize, though the new-normal economy will have a slightly different complexion given accelerated trends in technology and consumer spending habits, remote work conditions, changes in commercial and residential real estate investment, government expenditures and business investment.

2. Policy stimulus remains a tailwind as fiscal aid teams up with the Fed

  • We think fiscal and monetary policy will be a wind at the economy's back in coming years, supporting a sustained economic recovery. Historically, expansions tend to run out of steam as monetary policy (interest rate) settings become more restrictive. We doubt the Fed will raise rates or tighten policy anytime soon. At the same time, with Fed stimulus spigots already wide open and the economy still suffering the effects of the pandemic, we think fiscal policy will provide more help than hurt ahead.
  • Government spending as a percentage of GDP trended higher from the 1950s through the '70s. Since then, it has leveled off somewhat, moving higher during recessions and then gradually receding as economic conditions improve. We've seen a significant spike recently, and we expect the pandemic fiscal response from Washington to remain in place in the coming year to continue to bridge the lingering labor market and consumer divide created by the shutdown.
  • While unprecedented policy responses addressed the more immediate economic threat, this has potentially created longer-term implications, namely a bloated Fed balance sheet and rising federal budget deficits/debt. The former raises the potential for higher inflation down the road, while the latter raises the potential for eventual unfavorable fiscal choices (higher financing costs, higher taxes, spending cuts). Neither of these scenarios will come to a head in the next few years, in our view, but they will be legacy impacts of the pandemic policy responses that markets will grapple with over time.

3. Interest rates stay low for longer

  • Ten-year interest rates fell to record lows in 2020. We think two primary influences will keep interest rates relatively low in the coming year: sizable Fed stimulus programs and subdued inflation. We doubt the extraordinary Fed support will be unwound rapidly, as we expect the economic recovery to be gradual. A more vigorous economic rebound poses the greatest potential to spark higher inflation and interest rates, but we think this trend is more likely to play out over the next several years.
  • The Fed has introduced a new policy strategy to raise inflation toward a more desirable long-term level of 2%. Whereas the 2% target was historically viewed as a destination, U.S. central bankers will now allow prices to run above that level for a period in an effort to hit an average of 2% over time. We think this signals the Fed's commitment to keeping highly accommodative monetary policy in place for the next several years, which should help the economic recovery and equity markets. To the extent the combination of monetary and fiscal stimulus produces a lift in demand that guides inflation higher in the near term, financial markets would likely begin to fixate on the question of, "How far above its target will the Fed let inflation go, and for how long?" Similar Fed policy worries in 2013 and 2018 spurred market volatility and temporary pullbacks in equity markets as investors re-calibrated expectations for ongoing Fed stimulus.

4. Backed by a combination of growth and stimulus, the bull market continues

  • We think the gap between the economy and equity market will narrow in 2021. Stocks returned to new highs in mid-2020, while GDP remained well below pre-pandemic levels. The 60% market rally off the lows reflected the anticipation of an economic rebound, which we expect will continue through 2021, supporting further gains in U.S. equities.
  • Historically, when GDP is growing, corporate earnings are rising and monetary policy settings are loose – a combination we believe will persist through 2021 – the market has experienced positive returns.
  • The stock market has typically performed well in the year following a recession, bear market or election. This reflects the fact that economic rebounds, while often experiencing challenges in the early stages of the cycle, are typically enduring, with the average postwar expansion lasting nearly 4 years. At the same time, passing uncertainties, such as elections, tend to be a supportive catalyst, with markets averaging a rise of 7% in the calendar year after an election.

As we transition to 2021, remember that your financial goals, not the calendar or the twists and turns of the current environment, are the most important guide for your long-term strategy and investment decisions. Talk with your Edward Jones financial advisor about how you can best position yourself to stay on track toward your goals in the coming year and beyond.

Market returns in year following recessions, bears markets and elections

Source: Morningstar Direct, S&P 500 Price Return Index, SBBI IBBOTSON LT govt bond index. Past performance does not guarantee future performance.

Craig Fehr

Craig Fehr is a principal and the leader of investment strategy for Edward Jones. Craig is responsible for analyzing and interpreting economic trends and market conditions, along with constructing investment strategies and asset allocation guidance designed to help investors reach their financial goals.

He has been featured in Barron’s, The Wall Street Journal, the Financial Times, SmartMoney magazine, MarketWatch, the Financial Post, Yahoo! Finance, Bloomberg News, Reuters, CNBC and Investment Executive TV.

Craig holds a master's degree in finance from Harvard University, an MBA with an emphasis in economics from Saint Louis University and a graduate certificate in economics from Harvard.

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