Today’s global economic landscape and capital markets are laced with risks, given the unparalleled challenges stemming from COVID-19. Uncertainty is prevalent and pressures are being felt worldwide as economies grapple with the consequences of a once-in-a-century pandemic. As we look ahead, we believe economic and market uncertainty is likely to persist, stemming from historically high federal deficits, elevated equity valuations and concerns of inflation, creating implications for investors’ portfolios. In this article, we offer insight into key investment concerns of today’s markets and considerations for portfolios going forward.

The Federal deficit is at historically high levels

While the federal budget deficit has been on a slow upward trajectory for the past few years, the COVID-19 pandemic has incited an immediate need for additional federal spending. Following high unemployment and lost outputs resulting from shutdowns, economies across the globe fell into a sharp recession. In order to avoid lasting economic damage, the U.S. government passed a significant fiscal stimulus package aimed to provide individuals, businesses and governments with financial aid.

As a result, it’s estimated that the U.S. government has added ~$2.3 trillion to the federal deficit in direct response to the pandemic. The federal deficit totaled $3.1 trillion in the fiscal year 2020, more than tripling 2019 levels. In comparison, the deficit in the first six months of 2020 was just $0.7 trillion; meaning ~77% of the federal deficit was accumulated in the second half of the year1. At 14.9% of Gross Domestic Product (GDP), the 2020 deficit stands as the largest percentage of GDP since 1945 during World War II, up from 4.6% and 3.8% in 2019 and 2018, respectively.1

Such high levels of federal debt are uncommon and typically a result of an extenuating circumstance; the current peak being a direct reply to the unparalleled situation stemming from the pandemic. However, there are several implications of sustained high federal debt levels including having less flexibility to respond to challenges should they arise, like a war or natural disaster, and a greater risk of a fiscal crisis as investors raise concerns about the government’s ability to pay their debt.

In the coming months, we expect to see multiple rounds of fiscal policy and additional stimulus packages from central banks in order to stimulate demand and drive real economic growth and recovery – pushing those federal deficit numbers higher and higher. It would take unprecedented changes in taxation or spending, or a surge in growth, to bring debt levels back to pre-virus levels. These deficit levels, combined with a steepening yield curve and elevated correlations, may impede fixed income’s typical ability to provide ballast, particularly during a market downturn.

Federal budget and balance sheets

Information is subject to change and is not a guarantee of future results. Source: U.S. Department of the Treasury, Congressional Budget Office as of November 30, 2020. Graph shows cumulative deficits over the fiscal year, which begins in October.

The risk of a sell-off and elevated valuations within equities

Despite the many challenges confronting the general population and investors, U.S. equity markets have recovered from pandemic lows and are trading at or near all-time highs.

As investors and markets look to a recovery, equity valuations are at, or close to, historically high levels. We believe the elevated valuations of U.S. companies are being driven by consumer perceptions that the quality of the companies and their strong growth will continue in the future, thus justifying the premium. It’s important to note that forward-looking valuations may look particularly high given the recent pandemic-spurred recession.

As the saying goes, “what comes up, must come down,” – and as trading and valuation levels continue to rise, concerns of an impending downturn is increasingly on investors’ minds. While markets may experience volatility ahead, additional Federal Reserve stimulus and continued low rates should provide support to equities in the near-term. However, over the long-term, we believe that the rising volatility may create pockets of sudden and unforeseen stresses in markets that investors need to protect against.

Concerns of inflation

Already at low levels, inflation, as measured by the Consumer Price Index (CPI) dropped even lower following the pandemic-triggered recession. However, the massive amounts of monetary and fiscal stimulus flooding throughout world economies, combined with expectations of a steepening yield curve, has investors concerned about a sudden increase in inflation. We believe the shift of pricing power towards consumers, as well as careful management by the Fed, will keep inflation low over the foreseeable future. We believe that a sustained period of inflation may be visible in the medium term and, as such, investors should be aware of the risk, as it can decrease purchasing power and potentially cause wealth-erosion in client portfolios.

12-month percentage change, Consumer Price Index (CPI), All items

Past performance is no guarantee of future results. Information is subject to change and is not a guarantee of future results. Source: U.S. Bureau of Labor Statistics, data as of November 30, 2020.

Seek to balance limiting volatility and capturing growth with a protective allocation

With all the investment considerations we just reviewed, and expected ongoing market uncertainty, investors continue to struggle to find the balance between limiting volatility and capturing growth. Investors should consider a protective allocation for their portfolios; allocating across asset classes that have historically helped to protect capital in periods of stress, and that seek to deliver competitive returns in more benign market environments. To help address common investor concerns today, consider an asset allocation and security selection approach that invests in:

When pulled together into a diversified investment vehicle, like the Emles Protective Allocation ETF (DEFN), the result is an ETF that seeks to provide investors with competitive returns in strong market environments while protecting portfolios in periods of extreme market stress. With the Emles Protective Allocation ETF (DEFN), investors can potentially weather these risks ahead.

Tags: Capital Preservation, Commodities, Diversification, ETF, Inflation, Volatility