Markets Update: A Quarter in Review
The year 2020 proved to be one of the most tumultuous in modern history, marked by a number of developments that were historically unprecedented and unpredictable. It also demonstrated the resilience of people, democratic institutions, and global financial markets. Despite the extraordinary events of the first few weeks of 2021, and the likelihood we will have a very difficult winter, we are optimistic about 2021. Multiple vaccines have been approved and while off to a sluggish start, there is reason to believe distribution will improve rapidly and the pandemic will finally draw to end late this year. That is not to say there are not uncertainties around the pace of the recovery, ongoing political uncertainty, and millions of people without employment opportunities. After two very strong years, we caution clients to expect more muted returns in the near future.
ECONOMY
2020 was a year of extremes for the global economy and you can’t talk about the economy without talking about Covid-19. After surging in the spring and retreating in the summer, the pandemic has worsened in recent months and we are beginning to see the impact of the holidays in daily case counts. Not surprisingly, the unemployment rate mirrored these broad swings. U.S. unemployment hit a 50 year low in Feb 2020 of 3.5% and by April, 22 million people had lost their jobs and the unemployment rate was just below 15%. By the end of November, 12.3 million (58%) of the lost jobs had returned. While a historic number of jobs were created in the second half of the year, there is still a long way to go. Thankfully, central banks and governments worked hard to cushion the economic blow by providing financial support to individuals and business while rapidly lowering interest rates. Similar to last year, we expect the pandemic will dictate the course of expansion in 2021, with little to no growth early in the year and a strong recovery in the second half as people begin to be able to return to more normal activities.
STOCKS
2020 was characterized by sharp swings in the global stock market, mirroring the pandemic. March saw an eye-popping -33.79% drop in the S&P 500 and yet the index finished the year in record territory with a 18.4% annual return. The more interesting reflection is the broad dispersion in returns within the market. Retail, airlines, and hospitality suffered while communications, online shopping, home improvement, and technology seized on increased demand and had a banner year. The developed international markets, while not as robust as the U.S., posted solid returns with emerging markets up over 18% and international markets rose 7.6%. The end result in the U.S. was lofty valuations for stocks, especially the big name technology companies. Overall U.S. stocks ended the year priced at over 22x earnings compared to the 25-year average of 16x earnings. Overseas we see the opposite on the valuation front with both developed and emerging markets stocks selling at some of the cheapest levels relative to the U.S. in the last 20 years. In short, we see more upside in stocks outside of the United States in 2021.
BONDS
Bonds were not immune to historic swings during 2020. In the first quarter, U.S. corporate bonds underperformed U.S. Treasuries by more than 11% and then rebounded to outperform the U.S. Treasuries by 7.74% in the second quarter after the CARES act was passed. The Barclays Aggregate Bond Index ended the year up over 7%, reflecting the unexpected drop in interest rates caused by the Fed’s response to the pandemic. Moving forward, we expect bond yields to remain historically low and for the total return of fixed income investments to be muted. We continue to keep roughly 25% of our fixed income portfolio in short-term bonds, despite the low yields, as a hedge against equity volatility.
——
Topic of the Quarter: Dividends in the Time of COVID-19
Many investors view dividend payouts as a reliable source of income. However, those expecting to receive consistent dividend income may have been surprised to see lower than-expected dividend payouts following the onset of the coronavirus pandemic, when both market volatility and market declines were extraordinary. In reality, recent and historical data show that changes in dividend policy are common, especially during times of higher uncertainty.
Aggregate dividend payouts fell meaningfully in the first three quarters of 2020 compared to the same period in 2019. Exhibit 1 shows the dividends earned from a hypothetical $1 million investment in US, developed ex US, and emerging markets in both periods. Developed ex US markets showed the most drastic change with a 41% decrease. Dividend payments in emerging markets decreased by 29% and in US markets by 22%.
Globally, large firms have historically had the highest propensity to offer dividend payouts, but even successful, established firms were not immune to the economic consequences of a global pandemic. A few examples help illustrate this point. Harley Davidson (HOG) has been paying dividends to shareholders since the 1990s. In April 2020, the motorcycle manufacturer slashed its dividend from $0.38 per share to just $0.02, a 95% decrease. Gap Inc. (GPS) suspended its dividend payments until at least April 2021 after the economic downturn left the clothing brand with particularly poor revenues.
Harley Davidson and Gap were not the only firms to change their dividend policies. As shown in Exhibit 2, 38% of firms in global markets (2,584 companies) that were expected to pay dividends, consistent with their payout history, instead decreased, omitted, or eliminated their dividend payments in the second quarter, more than doubling the 1,248 firms that made similar changes to their dividend policy in the first quarter of the year. The trend continued into the third quarter: 2,699 firms made such changes.
While these dividend cuts may come as a surprise to some investors, history buffs may recall that, in 2009, Harley Davidson announced it was cutting dividend payouts from $0.33 per share to $0.10, a 70% decrease. In fact, during the Great Recession, significant changes to firms’ dividend policies spiked throughout global markets. Exhibit 3 displays Fama/French global market returns for 1991–2019 with a one-year lag and the proportion of dividend-paying firms that eliminated or decreased their dividend payouts. In 2008, for example, the global market was down more than 40%, and, the following year, many firms made changes to their dividend policies. The historical correlation between global market returns and dividends that are eliminated or decreased may suggest that firms are more likely to alter their dividend payouts during times of market instability.
The first three quarters of 2020 remind us that dividend payouts can be inconsistent, particularly in volatile markets. Hence, investment strategies that focus on income derived from dividends may not serve investors who need a steady income stream and, moreover, might not be the most effective way to pursue long-term wealth growth. A more reliable approach is to structure equity asset allocation around the characteristics that research demonstrates drive long-term higher expected returns, namely size, relative price, and profitability, while maintaining broad diversification across names, sectors, and countries.
Source: https://www.mydimensional.com/dividends-in-the-time-of-covid-19
——