Every year, there is plenty of investment advice on the best “buys” for the New Year! However, in 2021, it may prove just as important to avoid certain areas of the financial markets.
The current consensus forecast for U.S. real GDP growth is 3.9% in 2021, representing the fastest rate since 2000. Our prediction is for 6% growth—the fastest since 1984! Either way, due to massive policy stimulus and the expectation that vaccinations will finally bring COVID-19 under control, U.S. economic growth should be strong this year. Whether currently a bull or a bear, the fact that real U.S. economic growth is poised for a healthy advance should make everyone leery of traditional “defensive investments.”
Chart 1 overlays the annual growth in U.S. real GDP (red dotted line, inverted right scale) with the annual relative total return of a defensive investing proxy. The proxy comprises an equal-weighted index of traditional defensive sectors (S&P 500 Utilities and Consumer Staples), Gold, and the S&P 500 Low Volatility Index. Although not perfect, the correlation between the annual relative total return of defensive investing and annual real GDP growth is a strong -0.6 since 1992. It’s not surprising that defensive investments perform best during disappointing economic times and poorly when the economy is healthy. But this year, the relationship should be kept front of mind because 2021 is poised to produce the most vigorous economic growth in decades.
The impact a strong economy can inflict on defensive investments is highlighted in Chart 2; it displays a scatter plot of defensive total returns and real economic growth. Defensive investments underperform most frequently. Since 1992, they have outpaced the overall S&P 500 Index only 30% of the time. In seven out of ten quarters since the 1990s, defensive investing trailed. However, as shown, when defense wins, it tends to win big! Historically, defensive investments far outpaced when real GDP growth contracted, and they had some significant wins in quarters when annual growth in real GDP was less than 2.5%.
In recent years, the U.S. economy has experienced some of the weakest economic growth in its history. Economic contractions have been severe (2009 and 2020), and expansion-phase growth proved extremely subpar. Indeed, since 2000, U.S. annual real GDP growth has been below 3% more than three-quarters of the time. This unprecedented, disappointing economic era has made stars out of defensive investments. During this period, investors achieved considerable success by focusing on low volatility, gold, bonds, dividend aristocrats, and high-quality assets. Understandably, investors have been reluctant to move away from defensive investments, given their long-standing success. Consequently, most portfolios are probably still overweighted in these areas.
Nonetheless, this year, the best economic growth in decades could deliver a harsh penalty for defensive investments, as illustrated in Chart 2. The red dotted line shows when annual real GDP growth is 2.8%. Note that defensive investing has rarely won when real GDP growth rose above that level, and it frequently suffered severe underperformance.
Based on the regression equation shown, the current consensus real GDP growth expectation of almost 4% suggests the defensive investment proxy would underperform the S&P 500 by about 12%. If real GDP growth is closer to our estimate of 6%, defensive investments are poised to underperform by almost 23%! Since 2000, the defensive proxy’s relative total return trailed the S&P 500 by more than 10%, less than one-third of the time; it lagged by over 15%, only about 12% of the time.
Investors who thought they were responsible, cautious, defensive, and avoiding the popular, risky stocks, could be subject to unexpected pain in 2021 due to a solid year of U.S. economic growth not experienced in decades.
This analysis is based solely on the pace of economic growth. Whether you expect the overall stock market to rise or fall this year is immaterial. During the last 30 years, regardless of the market’s direction, defensive investing did well when economic growth was weak and poorly when growth was healthy. The stock market may rise or fall this year, but because economic growth is likely to be strong, defensive investments may struggle.
Everyone should own some defensive investments. They are necessary to be appropriately diversified. But don’t fall in love with your defensive winners of the last two-plus decades because 2021 is likely to deliver an economic growth rate never seen during that winning streak.