The Continuing Case for Cautious Optimism

Investors began 2021 filled with optimism about the markets, and there are good reasons for the positive attitudes.

Market prices indicate investors expect interest rates and inflation to stay low. They also expect corporate profits to improve due to a strong economic rebound once COVID-19 vaccines are widely administered.

The vaccines aren’t the only reasons for optimism. The Federal Reserve continues to make it clear that even when the pandemic fades, the U.S. central bank will print money and keep interest rates low until inflation is comfortably above 2%.

Likewise, fiscal stimulus is likely to continue and probably increase, especially after the change in power in Washington following the Nov. 3 election.

The Fed will continue to coordinate its policy with fiscal authorities. Essentially, the Fed is going to buy as much debt as Washington wants to issue. You can learn more details about this policy coordination in my Retirement Watch Spotlight Series episodes from April and December 2020.

Markets don’t like uncertainty, and it looks like there is going to be less uncertainty about fiscal and monetary policy than there has been in years. But that doesn’t mean everything is going to be rosy and we should abandon our insistence on having a margin of safety.

Low interest rates, coupled with the strong stock returns of the last few years, mean investment returns for the coming years are likely to be below average. I’m not forecasting a deep, long bear market. I believe the Fed will do everything it can do prevent that.

But stock returns aren’t likely to continue at recent levels.In addition, the wide dispersion between winners and losers will continue and might become even broader. We’ve seen significant differences in returns between companies and market sectors.

We’ve also seen wide disparities between countries. These performance gaps will continue.The United States and China are likely to continue leading the global economy and markets. Other countries, especially in Europe and Latin America, are likely to lag.

Earnings growth for many companies, especially the U.S. large growth companies that have been leading the way, are likely to be lower. There are a lot of strengthening headwinds. These include higher labor costs, increased regulation, more aggressive antitrust enforcement, concerns about privacy, tax increases and more.

The dollar’s value has been declining against many other currencies and gold. The dollar is down about 8% this year against a broad basket of currencies and about 5% in the last three months.

Most people don’t notice immediately a decline in the dollar, especially when inflation remains low. But over time, it reduces the purchasing power of U.S. consumers. We’ve been anticipating both a declining dollar and higher inflation.

The inflation increase is slow, but it will be steady. That’s why we’ve owned gold and Treasury Inflation-Protected Securities (TIPS). These will continue to be important investments.Interest rates will remain low and, after adjusting for inflation, many real interest rates are negative.

That will continue, as the Fed has made clear. Traditional bonds and fixed income investments remain bad investments.Fortunately, there are better choices, though they carry more volatility. These include preferred securities, some dividend-paying stocks, TIPS and more.

Investors who want to earn decent income and protect their purchasing power need to move away from the traditional income investments that worked so well since the early 1980s.

Something to be prepared for in 2021 is an increase in the number of corporate debt defaults. Some companies with high debt levels made it through 2020 thanks to careful management and help from the federal government and their lenders.

But if their revenues don’t bounce back in 2021 after the vaccines are widely distributed, their lenders could lose patience.

The companies could have no options other than default and bankruptcy. The potential for a rise in defaults is a good reason to ensure your portfolio is balanced and your investments have margins of safety.