The Case for Economic Optimism In '21

COVID vaccines and unleashed demand may provide tailwinds, but the year is not without risks.

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Market Review

While large tech companies greatly benefitted last year from the pandemic-generated work-from-home movement, price multiples on some of these tech darlings reached extreme levels, causing investors to shift their focus to underappreciated segments such as small-cap and value stocks. After lagging the broader equity market for years, domestic small-cap value stocks surged over 30% in the final quarter of 2020.

Other overlooked segments such as emerging-market equities gained nearly 20% in the fourth quarter. More broadly, international stocks outpaced the U.S. equity market after struggling earlier in 2020 to keep pace with U.S. tech leaders.

Within fixed income, high-yield bonds and emerging-market debt benefitted from the continued contraction in credit spreads since the spike in the first quarter of 2020.

Outlook

Though they experienced quite a roller-coaster ride, investors who held firm to their positions generally gained in 2020, as by year end nearly all markets erased significant losses from the first quarter. We anticipate that governments will remain highly accommodative amid these unprecedented times. Dispensing the COVID vaccine to the masses will likely accelerate the pace of the recovery in 2021 and beyond.

These two factors should bode well for further appreciation of risky assets such as stocks and credit.

COVID-19 Impacts

Although new coronavirus cases surged in the U.S. in the fourth quarter of 2020, the approval and implementation of vaccines provided a light at the end of the pandemic tunnel. An inoculated consumer base may unleash pent-up demand, especially for the services sector, which includes many smaller and cyclical value firms, that has been suppressed for nearly a year.

Small-Cap Recovery

The hope of additional fiscal stimulus and a relatively healthy global recovery fueled the strong runup in small-cap value. We anticipate the rotation between sectors and styles seen in the fourth quarter will carry momentum throughout 2021. Fundamental factors such as accelerating revenue growth and quickly improving earnings should be a tailwind for small-cap companies.

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Source: FactSet

Furthermore, the Biden administration may seek to level the playing field for various sectors. Such measures could include regulations that reduce monopolistic practices and/or hinder buyback activity, which would likely be headwinds for larger companies. We believe small caps and value stocks may, after over a decade of underperformance (on an annualized basis), be better positioned than their larger growth counterparts.

China

We continue to expect the Biden administration will take a different approach to China compared to President Trump’s aggressive tactics, which caused China to respond with its own aggressive measures, including a military presence around strategic assets in key regions.

President Biden will have to deal with Chinese President Xi Jinping, whose long-term vision for his country is to be the world’s dominant superpower. Biden will need to maintain a delicate balance of carrot and stick to convince China to play fairly and abide by global standards of trade and business. While Trump may have tried to simply contain China’s growing power and influence, Biden will probably need to take a different approach of being stern yet taking the time to understand China’s true objectives. Biden is also likely to shore up ties with old allies, such as the European Union, to help pressure China. The specter of military involvement between superpowers may loom if animosity between China and the U.S. rises to untenable levels.

Given the deteriorating relations between the West and China, we could potentially end up with a divided digital world that is run on two 5G platforms—one based on Western standards and the other driven by Chinese systems. The outcome from segmented technology will also depend on many factors, including how respective countries treat and regulate their domestic conglomerates such as Facebook and Google for the U.S. and Alibaba and Tencent for China.

A Reshaped Foreign-Exchange Market and Cryptocurrencies

Cryptocurrencies such as Bitcoin continued to gain momentum in 2020, enticing traders to invest in those volatile investments. Many of these cryptocurrencies bear little-to-no fiat value, but Facebook, for instance, has been preparing to launch Diem (previously called Libra) that would be backed by traditional currencies such the U.S. dollar, euro and yen. Cryptocurrencies such as the Diem have the potential to uproot traditional central banks and their ability to conduct monetary policies. In other words, the Fed may have less control over interest rates, which in turn can impact discount rates and market valuations.

The New Modern Warfare

While the likelihood of escalating military conflict has risen in the South China Sea region, many of today’s battles are fought through economic and political measures. Foreign hacks into U.S. government and company computer systems continue to rise with the potential to do tremendous damage to the U.S. economy and erode confidence in security. Information security will likely become an increasingly important area of interest. Investors may now prefer to seek protection amid this environment.

The U.S. network-infrastructure market continues to evolve, as cyber threats affect all sectors and industries. The cybersecurity industry continues to grow with hundreds of new startups being launched every year with venture capitalists investing at a record pace. Some of the companies gaining market share in this cybersecurity industry include Crowd Strike and Fortinet, which are listed in the Russell Mid-Cap Growth Index; some of the larger and established players include Cisco Systems and IBM, both of which are represented in the Russell 1000 Value Index. Developing trends in the network security industry could also remain positive for small- and mid-sized cybersecurity companies, as larger entities may look to consolidate. The positive momentum and necessity for better information protection should boost demand for services offered by cybersecurity providers.

Conclusion

In general, we see economic optimism generated by the COVID vaccines and unleashed pent-up demand caused by the pandemic. We also believe the latest tech revolution, driven by COVID and its related shutdowns, will enhance productivity, which should support risk assets. Other potential investment bright spots in 2021 include small-cap and value stocks, which we believe will have tailwinds this year, and cybersecurity companies that will likely experience increased demand from governments and firms due to the escalating number of hacks.

But like 2020, this year could experience significant headwinds, including the deterioration of U.S.-China relations, the continued foreign hacking of U.S. digital infrastructure, and the lingering effects of the pandemic – especially as there are several remaining hurdles to scaling up vaccine distribution.

We will remain optimistic about carefully considered investment opportunities in 2021, while being mindful of potential pitfalls.

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Past performance does not guarantee future results. All investing involves risk, including the possible loss of the principal amount invested.

Pacific Asset Management LLC is the sub-adviser for the Pacific Funds℠ Fixed-Income Funds. The views in this commentary are as of January 9, 2021
and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Any performance data quoted represents past performance which does not guarantee future results. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.

Sector names in this commentary are provided by the funds' portfolio managers and could be different if provided by a third party.

Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.

Pacific Funds and Pacific Asset Management LLC are registered service marks of Pacific Life Insurance Company (“Pacific Life”). S&P is a registered trademark of Standard & Poor’s Financial Services LLC. All third-party trademarks referenced by Pacific Life, such as S&P, belong to their respective owners. References of third-party trademarks do not indicate or signify any relationship, sponsorship or endorsement between Pacific Life and the owners of referenced trademarks.

Pacific Funds are distributed by Pacific Select Distributors, LLC (member FINRA & SIPC), a subsidiary of Pacific Life Insurance Company (Newport Beach, CA), and are available through licensed third parties. Pacific Funds refers to Pacific Funds Series Trust.

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