2021 Economic and Investment Update

And good afternoon, good day everybody. My name is George Mateyo. I'm the Chief Investment Officer here at Key Private Bank. We wanted to get everybody together to talk about some themes for 2021 and give you our thoughts on the economic and investment outlook as we see it going forward. I'm joined today by two of my colleagues from the Private Bank both Steve Hoedt, our Managing Director of Equity and Fixed Income Research and also our colleague Rajeev Sharma, our Managing Director of Fixed Income, Portfolio Management. Also, I have a special guest for this from KeyBanc Capital Markets, Jordan Sadler is also in the studio with us today, and we'll share some insights from the capital markets perspective as well.

So, if I think about where we stand now in early 2021, I think it's maybe important for us to take a few seconds and look backwards in terms of what we thought might happen in 2020, which seems like a long time ago, and indeed it was. Clearly, we did not foresee a pandemic of global proportions; we didn't see the worst healthcare crisis in over a century, the worst economic decline in nearly 90 years, and also the fastest stock market decline followed by the quickest recovery. But what we did see actually happening in 2020 was maybe two scenarios that we characterized as the new productivity paradigm and also the new economic paradigm.

Under the new productivity paradigm, we talked about how artificial intelligence, cloud computing, e-commerce, and other things could really lift the economy in a significantly higher growth trajectory while at the same time keeping a lid on inflation and, to some extent that happened through the advent of the pandemic. E-commerce, as we all know, has really soared. Other things have taken off materially higher to really lift the productivity of our economy quite significantly as well.

The other scenario that we envisioned in 2020 had to do with what we call a new economic paradigm, and under that scenario, we thought interest rates might fall to zero, government spending might surge, deficits might also balloon, and they could actually, at some point maybe, kind of sow the seeds essentially for inflation at some point down the road.

And so oddly enough, both of those two scenarios while they seem somewhat disconnected from each other, did materialize both in 2020 and throughout the pandemic that is hopefully just ending. So, as we think about 2021, we characterize this as a year of reflation and convergences. We note, for example, that we've seen many industries have been dislocated because of the pandemic, and as vaccines become more widely available, we can start to see some of those dislocations close and some of those companies that have been adversely impacted by the pandemic start to strengthen a bit and recover somewhat going forward.

We've also seen a lot of attention focus on Big Tech, as we call it. Technology companies have been really at the epicenter of change that accelerated through our economy, but at the same time, they've garnered a lot of attention from regulators and others as well that maybe suggests that they might have some difficulties going forward. Relatedly, we've also started signaling that valuations in the U.S. stock market are somewhat elevated. They're less so in the rest of the world, and perhaps as the economy starts to broaden out through other parts of the world, we might see some of those convergences take place between the U.S. market and international markets as well.

And then thirdly, as it relates to what happened with respect to COVID, in particular, we certainly saw a significant demand shock in the aftermath of the COVID-19 and the economic response to COVID in spring of last year. Since then it created somewhat of a supply shock, and we're starting to see some pressures build up that suggested maybe inflation might be something to contend with later this year.

And then fourthly, we're also cognizant of the fact that the dollar might weaken as a result of some of these trends as well. They can also spur some inflationary pressures at home that we have to be mindful of. So, let me turn it over to Steve, first of all, to get some thoughts from him. We've obviously talked about reflation, and one of those things we're starting to see, I think, is on the earning side. Steve, can you give us an update on the earnings outlook for 2021?

Thanks, George. So yeah, what you see here is the index aggregate earnings for the S&P 500 in the red line, and the blue line is the S&P 500 itself, and what we've observed historically is that price tends to lead our earnings at terms in the market. However, when the market is in motion, the most important thing is the continued momentum in the direction that earnings are going, and what we've seen off of the lows last March is an astounding recovery in forward earnings expectations for the market. We saw earnings estimates for the forward 12 months get cut sharply as we went into the pandemic, and while we have yet to recover to new highs, within about $8 right now of where peak earnings were prior to entering into the pandemic.

And if you go out into late this year and think about what 2022 earnings look like, they significantly exceed where we are at today. So, I think that we've talked in the past, George, and for me, it comes back to the direction of the earnings trend is one of the most important things, and if the earnings trend is up, it's really hard for stocks not to be trending higher.

So that's a really great perspective, Steve, to talk about earnings at the macro level and certainly recognize the fact that we are now achieving peak earnings again despite the fact that we've seen a significant deceleration in earnings through much of 2020.

Jordan, let me bring you into the conversation. You obviously follow a number of companies very closely and probably have a different perspective or maybe a similar perspective, but maybe you could share your insights with respect to the earnings outlook for some of your companies.

Thanks George, and glad to be with everybody today. It's a good jumping-off point within the REIT sector. There are almost a dozen property subsectors ranging from, you know, the data centers and towers and industrial REITs, which benefited tremendously during the course of the pandemic as the world shifted toward a work, live, play from home dynamic. Data centers became essential to what we do, you know, from home. Whereas e-commerce drove substantial demand for industrial.

These trends, many of which were in place pre-pandemic as you had discussed in your remarks George, have really accelerated during the downturn and during the pandemic and very much at the expense of other sub-sectors like physical retail, the malls, the shopping centers of the world and also at the expense of office buildings whereas many folks are working from home and so what we saw throughout most of 2020 is we saw, you know, negative earnings revisions, sharply negative earnings revisions for these less fortunate property subsectors like retail, office, and hotels as many people can imagine.

And as we've sort of rolled through 2020 into early 2021, there's been a bit of a reversal and so these growth sectors, the data centers, towers and industrial for example, outperformed and exceeded the REIT index overall roughly by about 2,500 basis points last year or 25%. These value sectors were really on the other end of the spectrum, roughly about a 20% or 25% underperformance versus the sector. So, a very wide disparity.

And once the vaccine was announced in November, we saw a move or a retracement that started where people started positioning out of growth and back into value. So essentially out of the data centers well and in towards hotels and office and retail and what we're seeing from an earnings dynamic as we've just making our way through, you know, at least the first half of the fourth-quarter earnings season is we're really resetting the bar.

The fourth quarter was a great quarter for the data centers and the towers, and these industrial REITs. They continue to see outsized demand and steady demand and demand generally outstripping supply. Although a lot of capital is coming into this space, and they're forcing returns lower in those places, and they are driving, and that's causing the effect of creating potentially a little bit more supply. So that's something to be mindful of.

And on the other side, the retail REITs and the office landlords and the hotels, they've reset the bar. There's a lot of consternation around work from home and how that reflation is going to figure into offices longer term. But there is an expectation that retail will actually do a little bit better as we've seen a deurbanization. People have moved out into the suburbs a little bit more, and they're working from home. So, they need to go pick up lunch at the local shopping center. So that's going to increase traffic in retail a little bit more, and so physical retail is actually looking a little bit brighter.

On the hotel side, while the outlook is a little bit longer tailed, there is the potential for people to get back to leisure travel and eventually, hopefully, business travel as the population is vaccinated. And, you know, through this morning, I think we've got North of 50 million vaccinations administered so far, and so, you know, we're starting to make some progress there, and that's what we're continuing to see, you know.

In earnings we see a little bit of a rebasing and acceleration off of a bottom in 2020, for these value sectors and probably a moderation gradually for the data centers and the industrial and towers REITs if you will or the former growth sectors. So, I guess sort of wrap it up there, pass it back to you, George.

Great, very interesting dichotomies for sure. So, thanks for calling some of those out, Jordan. I think those are really interesting insights and, again, generally speaks to some of the themes we've been talking about around some of these dislocations starting to converge a little bit and as you've pointed out, maybe some of the sectors are, that some of the sectors that outperformed perhaps are narrowing and maybe moderating a little bit where other sectors that were really impacted most acutely by COVID-19 are starting to see their fortunes turn up a bit.

So that's a good segue way into the related theme that we've also talked about for our 2021 outlook, which has to do with inflation to be emerging. To be true and to be clear, we're not signaling massive runaway inflation such as what we saw decades ago, but clearly, inflation is starting to perk up in certain parts of the economy that we need to be mindful of.

And so on this chart, we've got a chart here that shows you essentially the five-year forward projected inflation rate, and it's recovering, it's coming close to 2% which is essentially where the Fed I think is anticipating or thinking that inflation might start to be a problem. Although, I think last year they also started to shift their language a little bit and suggested that they could actually allow inflation to get a little bit hotter and higher before they started to tighten interest rates. So that's a good segue rather to bring in our other colleague Rajeev Sharma to give us some thoughts on interest rates and also some outlook for the Fed. Rajeev, good afternoon.

Hi, good afternoon, George. Thank you very much. Yes, as you can see with rates over here, it's another market signal for us. We've seen that long-term rates have moved higher in anticipation that the fed would not be able to control inflation as we've just mentioned. If inflation starts to run away from the Fed's target, which they have now an average inflation target of over 2%, and if we start to run away from that, the interest investors out there are worried a little bit that the Fed would not be able to control that, and if that's the case, rates will continue to move higher. So just this year alone, we've seen the long-term rates move up, and we’ve seen 10-year rates move about 25 basis points higher. As the year began, we were at 1.17%, which is the highest right now for the year, and we could see an overheating in inflation, and that could cause these rates to go even higher. So that's what we're looking at right now.

I think what would break this scenario down a little bit is if we had disappointments in economic leases such as the CPI, where we saw decline in commodities, or if we saw a stronger USD, these could all work to bring rates back down to some normalization. You also have the Fed watching this very carefully. Inflation is on the Fed's radar. They have been repeatedly stating that they don't anticipate moving at all anytime soon, they're kind of reaching all their mandates before they do any changes to their rate policy, but they are watching rates move up, and if they get to a point where they would, the Fed feels uncomfortable they could step in and start buying bonds at the longer term and try to bring rates down in some form of yield curve control.

Super Rajeev, thanks very much. So maybe again, I'll flip back to Jordan for a second because obviously, many of the sectors that you talked about are somewhat sensitive towards higher interest rates and also inflation pressures, although some probably you can benefit from that too. So, Jordan, as you think again about your coverage area, how does inflation ripple into your thinking and in interest rates rising, and what does that mean for you and your companies?

That's an excellent question. REITs are a levered asset class with real estate broadly throughout the commercial world and institutionally held real estate, in particular, tends to have some leverage associated with it in the 30, 40, 50% range and in the private markets even more so.

And so, what happens with interest rates, there tends to be an impact directly over time from moves in longer-term interest rates. But let's, it's worth taking a look back at history, especially as it relates to the Fed, in terms of what rates and REITs mean for one another. So 2020 was the fifth year in a row that REITs underperformed the broad market. I would say REITs are due versus equities and a look back at history, let's look at the great financial crisis as the most recent data point for us. REITs underperformed equities pretty dramatically in 2020 it was essentially 2,500 basis points, and looking back at the last time that we saw that degree of underperformance, looking back at the financial crisis, post-financial crisis, post-2007, 2008, REITs outperformed the broad market in six out of seven years as the Fed was, you know, stimulating and printing. Essentially, the Fed expanded its boundary back then by three and a half trillion dollars, and they've done that again, you know, more recently. So, you know, our expectation is that short-term rates are poised to remain low for a significant time.

REITs are more historically correlated with long-term rates, 10-year treasury if you will, and while that recent correlation is broken down somewhat and REITs have underperformed despite the fact that the 10-year has fallen by, you know, almost a hundred basis points from a year ago that leaves some cushion to the extent that long-term rates moved up closer to 2%. So we've seen this bounce off the bottom in long-term rates, but REITs never really tracked in this COVID downturn long-term interest rates. So, I think there's some cushion for long-term rates to move up. I think we'll more closely track what happens on the short end for a while, and as long as the Fed is printing and stimulating, I think we'll continue to have some runway as long as inflation does not get ahead of itself and rise dramatically.

Now, the thing about REITs and inflation is that REITs are actually a mechanism to hedge yourself against inflation. These are real assets, and the way that you're typically hedging yourself, not only from asset appreciation or levered asset appreciation as it were, you also have the ability to push rates as inflation flows through. So, if it's more expensive to build an apartment building, ultimately, you should be able to increase rents on an annual basis in apartments. Self-storage or hotels, hotels reprice every night. So, if prices do escalate to the extent they're escalating as a result of increased demand, you do have the ability to reprice these portfolios especially shorter-term lease property sectors, reasonably quickly, and so there is some protection in there. So that's how we think about REITs and rates and inflation.

That's really quite interesting Jordan, and again, because of the fact that I think some companies actually might benefit from higher interest rates going forward and even a bit of perhaps "good inflation," it sounds like. You know, before I let you go, Jordan, though, I'd be remiss if I didn't ask you to talk about the office market. You touched on that briefly, but I know that's an interest to a lot of our clients in general, and a lot of people have their own, I guess personal views on return to work, return to the office. But from your perspective, though, what is the outlook in the near term for the office sector?

It's a great question, and it's probably the one that's, gets the most airtime these days with investors. So, office buildings are currently under duress, especially in gateway cities, places like San Francisco and New York where you have, you know, reasonably high density within these office buildings traditionally and in some cases, you're constrained by public transit, particularly in New York area where people are commuting from the suburbs on crowded trains and potentially subways. Work from home has worked efficiently for some businesses and for certain executives and employees, and for others, it's worked less well. It's less conducive.

If you have a comfortable home with an office, you know, in the suburbs and your job enables you to work individually, you're in reasonably good shape. If you're a younger person in a smaller apartment with multiple people and it's hard to get privacy or some of your own space, and you really don't know a lot of people professionally yet, you haven't built out your Rolodex, that's a little bit more challenging. You know, a lot of young people graduate from college and move on to build a career, and they want to be in an office environment to meet people and network and learn and so that, we have not been able just yet to sort of supplant that piece of the equation and young people I think, in many ways make the world go round or are certainly the future. So, we will still need to figure that out.

So, I still think there's going to be a place for office, but in the near term, work from home, which has worked reasonably well, is still going to be, is probably going to be a spot that takes share. In other words, people will work from home incrementally. We will probably figure out, you know, more hoteling. Certain companies that work extraordinarily well from home, they found out we'll give up office space and others will take more office space, make more room for employees. So, they're not on top of each other, so there's greater, less density, greater space per capita. We have been contracting for years. So, the jury's still out a little bit George on what happens with office. But in the near term, we think there are going to be demand headwinds as companies are contracting.

Salesforce is looking to give up space they recently just took, and many other tech companies looking to give up space. Even the Gap is going to give up some space in San Francisco, but others are going to be opportunistic and despite the fact that places like Twitter are saying, Jack Dorsey [Twitter’s CEO] is saying that they can work from home forever. Cash App, one of their sister companies, just signed a lease for 40,000 square feet in lower Manhattan. So, you can't believe everything you read. But there is an important place for office in our world in terms of employment and careers for young people, and we'll really just need to see how it figures out I think in short-term, it's going to be a headwind and then there's going to be some shifting but the longer term, I still think there's going to be a place for office.

Very interesting, Jordan. Great, thanks very much and like anything, I guess in life, it's kind of location, location, location. So that's really terrific insights from everybody. Thanks so much for those comments.

Maybe I can close it by a few things that we learned from 2020 and also perhaps a few reasons for hope as we turn to 2021. You know, the first thing that we look at from the market's perspective is that investors really shouldn't fight the Fed. Clearly, with the benefit of hindsight, we can see just how much ammunition the Fed put forth to try and stave off the crisis—injecting massive amounts of liquidity to the system at a time it was needed. It really provided the support that allowed risk assets to stabilize in the early part of March and April of last year.

At the same time, we also would recognize that we shouldn't bet against human ingenuity. We didn't really talk about it much on this conversation, but perhaps on a separate conference call or a podcast, we might talk a little bit more about the vaccine development. It's been just massive to see what's happened there and now that we have two vaccines actually out in the marketplace, again gives us further optimism around the state of the economy, its ability to reopen, and also some of these divergences that we've talked about maybe start to narrow a bit. From the portfolio perspective, we've been saying this a lot in the last 12 months or so that sometimes doing nothing is better than doing something, and I think that's probably reflective of the fact that you need to have a true, strong, robust investment plan but given the tremendous amount of volatility that's associated with the markets from time to time, sometimes just adhering to your long-term policy, is perhaps the best prescription for panic in our view.

We also recognize that change is accelerating at an ever-accelerating pace that we believe has manifested itself in many different ways that I think Jordan and Steve and others have talked about, and I think it's worth reflecting on that too.

But perhaps the greatest and perhaps the most, I guess, the highest, best silver lining that emerged from the pandemic, is the fact that I think it's teaching all of us a degree of patience, humility, empathy and really just a general consideration for others that I think will hopefully endure much longer than the pandemic will. So, thank you, everybody, for joining us today. We hope this was interesting. We look forward to having these conversations in the future, and if you have any questions, please contact us at any time. Thanks very much.

While we did not foresee the worst healthcare crisis in over a century, the worst economic decline in 90+ years, the fastest 30+% stock market decline followed by the quickest recovery, we posed two scenarios that could unfold over time.


We labeled the first of these scenarios “a new productivity paradigm” in which artificial intelligence, cloud computing, and e-commerce could propel the economy to a higher plane of growth while simultaneously keeping a lid on inflation.


The second scenario we envisaged was “a new economic paradigm” in which interest rates fall to zero and gov’t spending and deficits surge. This would ultimately sow the seeds of inflation and heighten the need for new investment tools.


The future arrived early.

Key Private Bank Investment Center Podcast

Listen to this Key Private Bank Investment Center podcast as Chief Investment Officer George Mateyo is joined by our Key Private Bank Investment Center Experts and special guest Jordan Sadler, Managing Director with KeyBank Capital Markets, for an updated 2021 Economic Outlook. Listen in as our team cuts through the noise to deliver a complete update based on all of the critical market storylines, including:

  • The impact of the COVID-19 vaccine.
  • Potential for Big Tech to garner attention from regulators moving forward.
  • An analysis of valuations in the US vs. the rest of the world
  • The likelihood of the US dollar weakening and the potential for inflation in this ultra-accommodative Federal Reserve era; and more.

Any opinions, projections, or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

This material is presented for informational purposes only and should not be construed as individual tax or financial advice.

KeyBank does not provide legal advice.

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