Light at the End of the Tunnel: The Economy and Markets Post-COVID-19

March 19, 2021
In the feature article of this issue, BBH Chief Investment Strategist Scott Clemons reflects on the economy and markets since the onset of COVID-19 and looks ahead at what is to come as the light at the end of the tunnel grows brighter.

As the great American philosopher Yogi Berra once observed, “It’s tough to make predictions, especially about the future.” Investors are inherently betting on a future state of the world: a state in which financial markets recognize the fundamental value of a business, dividend and interest payments are made on time, tenants pay rent to landlords – all the things that create return on investment. Fundamental research and a keen attention to value help to identify specific opportunities for return, while at the same time mitigating the risk of something going wrong. Occasionally, something truly unique or rare happens that affects all asset classes, and Professor Berra is proved right once again. In March 2020, things went really wrong in the United States, as the societal, economic and financial consequences of the COVID-19 pandemic quickly became evident. In the same way that an earlier generation was forever influenced by coming of economic age during the Great Depression, so, too, will we be forever changed by the experience of the past year.

The good news is that there is good news. Daily diagnoses of COVID-19 peaked in mid-January and have fallen almost 80% since then, despite concerns that colder weather would lead to more infections at indoor gatherings, and despite the worrisome mutations of the coronavirus. New case diagnoses are declining in every state, and hospitals are no longer stretched to capacity. The Food and Drug Administration granted emergency use authorization to Johnson & Johnson’s ENSEMBLE vaccine in late February, so there are now three vaccines in distribution in the United States. As of mid-March, about 20% of the population has had at least one shot, and this figure will continue to rise rapidly throughout the spring.

Chart showing total U.S. COVID-19 cases and daily diagnoses from 3/1/2020 to 3/10/2021. As of 3/10/21, cases stood at 29,152,716, and the seven-day average of new cases was 56,105.

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There is light at the end of the tunnel, although it can sometimes be hard to make out through an N95 mask and fogged glasses.


The economic price of COVID-19 pales in comparison to the human toll. Over 530,000 lives have been lost in the United States, on top of an additional 2 million deaths elsewhere throughout the world. The disruption to lives, families and loved ones will linger for years to come. The economic recovery, on the other hand, has unfolded rather quickly and easily, at least at the macroeconomic level. After an unthinkable contraction of 31.4% in second quarter 2020, gross domestic product (GDP) rebounded at a similarly startling pace of 33.4% in the third quarter, before ending the year at a more modest growth rate of 4.1%. By statistical convention, GDP growth is calculated on a quarter-over-quarter basis, and then reported at an annualized rate. The 31.4% drop in second quarter 2020 was therefore in reality a decline of around 7% quarter over quarter, which annualizes to the reported figure of 31.4%. Economic volatility in 2020 was unquestionably pronounced, but not as drastic as the headline figures would indicate.

However calculated, a drop of 31% followed by a gain of 33% still leaves the economy short of where it started. Absolute GDP, adjusted for inflation, remains 2.4%, or $470 billion, below the previous peak of fourth quarter 2019. We will undoubtedly close this gap by the summer of this year, but only after losing almost two years of economic growth.

Chart showing real gross domestic product in trillion dollars from 3/31/2005 to 12/31/2020. The chart has recessions shaded and shows a $470 billion drop in GDP, or decline of 2.4%, during the market contraction in 2020 caused by the COVID-19 pandemic.

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The nearby graph of absolute economic output illustrates the unusual nature of this recession. The shape of this cycle is literally and graphically different from economic contractions of the last 60 years. Most recessions occur for one of two broad reasons: either the Federal Reserve raises interest rates and tightens monetary policy to prevent an economic expansion from overheating, or excesses on Wall Street lead to financial disruption that translates to Main Street. Either way, the economy gently rolls over (although it doesn’t feel gentle while it’s happening), finds a bottom when a combination of easier fiscal and monetary policy begins to work and gradually recovers to a previous peak. For example, during the 2007-2009 global financial crisis, economic output contracted by a total of 4% over a year and a half, and from that bottom took an additional two years to return to the prior peak level of output.

This time is different. Monetary policy was not tight at the onset of the pandemic, and no bubbles were bursting on Wall Street. Instead, this was a rare recession of our own making: Policymakers and politicians proactively chose to restrict certain economic activity to slow the spread of the coronavirus, thereby creating the shortest and sharpest economic cycle in history. In 2020, the pace of economic activity contracted by 10% in a mere two quarters (peak to trough) and will likely rebound to prior output levels within a year of last summer’s bottom. The difference in the two cycles highlighted in red on the graph is striking.

This time is different, though, only because it hasn’t happened in a long time, and now it’s happening to us. Although we don’t have robust economic data from the period of the 1918-1919 Spanish flu, contemporary news coverage implies that the economic toll was similar, as businesses, schools, restaurants and theaters closed while families quarantined at home to avoid contracting a disease for which there was no cure or vaccine. Fast forward to the so-called Asian flu of 1957-1958, and the pattern is similar. Here, the rapid development of a vaccine curtailed the human and economic toll. Nevertheless, at the height of the Asian flu pandemic, U.S. GDP (which was reported more robustly by this time) contracted at an annualized pace of 10.0% (first quarter 1958), a dubious record that stood unchallenged until a year ago.


Massive government intervention has driven the first phase of the current economic recovery: The second phase of sustainable expansion must be led by a rise in consumer spending. At almost 70% of GDP, personal spending is the durable engine of economic growth that government spending can never be. Unfortunately, measures of consumer confidence remain depressed, and as of February stand even slightly lower than they were in summer 2020. This bodes ill for consumer spending, at least in the very near term, as worried people do not tend to spend a lot of money.


Chart showing consumer confidence – including current sentiment and future expectations – from 12/31/1999 to 2/28/2021. Current sentiment stands at 86.2, and future sentiment stands at 69.8.

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This is not surprising. It has been a long and dark winter, both literally and figuratively, with little to be confident about. In addition to the pandemic, we, our friends, neighbors and colleagues spent the last year wrestling with political drama, raw reminders of social and racial inequality, concerns about children and remote learning, uncertainty about the timing and availability of vaccines and the general ennui that accompanies the Groundhog Day existence that has become our daily lives. Here, too, there is light at the end of the tunnel. These issues will continue to weigh on confidence for some time, but as the fog of uncertainty lifts (and as spring springs), we expect to see an improvement in these confidence surveys.

Once confidence rebounds, there is fortunately plenty of money to be spent. One of the more dramatic developments in this economic cycle is the increase in personal savings. Personal income rose sharply in April 2020, due largely to elements of the March 2020 Coronavirus Aid, Relief, and Economic Security Act (CARES Act), while at the same time personal spending collapsed, as people sheltered at home and only bought necessities.


Chart showing personal income and spending from 1/31/2006 to 1/31/2021. There is a $4.4 billion gap between the two.

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In the waning days of 2020, Congress passed the Continued Assistance for Unemployed Workers Act, which extended federal unemployment benefits, added funds to the Paycheck Protection Program and issued $600 stimulus checks for lower-income Americans, among other things. This additional fiscal stimulus appears in the January personal income statistics, leading to an additional sharp rise in income, and a savings gap of $4.4 trillion, or about 20% of GDP. Not all of this accumulated savings will be spent; as the graph makes clear, the income and spending lines never converge completely. Nevertheless, if the national savings rate returns to the average level of the last decade, this still represents roughly $3 trillion of “excess” savings, or about 14% of GDP.

But wait, as they say on TV, there’s more. The American Rescue Plan, signed into law by President Biden on March 11, increases child tax credits, extends federal enhanced unemployment benefits again through the end of August (originally scheduled to expire on March 14) and offers additional stimulus checks of up to $1,400 per eligible person. This will boost spendable income even further over the next few months.

Untitled Document

A Brief History of Government Pandemic Responses
Legislation Enactment
($ billions)
Coronavirus Preparedness and Response Supplemental Appropriations Act March 6, 2020 $8.3
Families First Coronavirus Response Act (FFCRA) March 18, 2020 $192.0
Coronavirus Aid, Relief, and Economic Security Act (CARES Act) March 27, 2020 $2,225.0
Continued Assistance for Unemployed Workers Act December 27, 2020 $915.0
American Rescue Plan March 11, 2021 $1,900.0
Total   $5,240.3
Source: Congressional Budget Office and BBH Analysis.
Data as of March 11, 2021.

With the implementation of the American Rescue Plan, the fiscal response to the pandemic adds up to $5.2 trillion of economic support, or 24% of GDP. This total makes the $939 billion of fiscal stimulus issued during the global financial crisis seem like a rounding error.

Additionally, monetary policy remains as accommodative as fiscal policy. As economic restrictions expanded rapidly in March 2020, and financial markets swooned, the Federal Reserve threw the whole financial crisis playbook at the rapidly spiraling COVID-19 economic downturn, slashing interest rates to zero, enacting a wide range of market support mechanisms and restarting balance sheet operations in order to lower longer-term interest rates. It worked. After a month fraught with volatility, financial markets calmed down by the end of March. A full year later, most of this monetary accommodation remains in place. Policy interest rates are still anchored close to zero, and the Fed continues to expand its balance sheet, which is now $3.4 trillion larger than before the pandemic, and up $195 billion just since the beginning of 2021.

Fed Chairman Jay Powell seems committed to staying this course. In his annual Humphrey-Hawkins testimony to the Senate Banking Committee in late February, Powell noted that “the economic recovery remains uneven and far from complete, and the path ahead is highly uncertain.” The market has heard him loud and clear: The futures market for the fed funds rate is currently pricing in a single rate increase around the beginning of 2023, with another to follow closer to the end of 2025. The market expects interest rates to stay lower for longer.

This graph shows the fed funds rate and fed funds futures from 2005 through 2026. The chart shows rates rising from 2016 to 2019, before dropping to near zero again in 2020. Looking further out, the data indicates that rates are expected to stay lower for longer.

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This combination of developments is a recipe for an accelerating economic rebound as 2021 progresses. Once vaccinations get us closer to herd immunity, open economies and restored confidence, then excess savings and pent-up demand will fuel an economic rebound, while the Federal Reserve has promised to keep the economic party going by refilling the punch bowl of low interest rates and continued monetary stimulus. What’s not to like?

The Price Tag

As the old saying goes, there are no free lunches, on Wall Street or elsewhere. At what price do we enjoy these economic tailwinds, and what risks accompany this otherwise favorable backdrop for the economy, corporate earnings and markets?

The first economic risk is that the colossal amount of fiscal support outlined above is simply not sustainable. Although precious few deficit hawks currently roam the halls of Congress, at some point stimulus checks, enhanced unemployment and payroll protection support will stop coming. Prior to the onset of the COVID-19 crisis, government transfer payments accounted for about 17% of household income. This includes, among other things, Social Security payments, Medicare, Medicaid, veterans’ benefits and the Supplemental Nutrition Assistance Program (formerly known as food stamps). This figure has risen gradually over time, averaging 13.4% in the 1990s, 14.5% in the 2000s and 17.2% in the 2010s.

Chart showing transfer payments as a % of household income from 1/31/1959 to 1/31/2021, with support spiking during the COVID-19 pandemic and the latest figure at 26.9%.

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The implementation of the CARES Act sent total government support soaring to over 31% of household income in April 2020, and this figure remains at 27% of total income as of January 2021. In other words, much of the excess savings discussed earlier is due to government programs that are not infinitely renewable. The economy – and the labor market in particular – needs to recover so that households are no longer reliant on extraordinary government support to function.

A second risk is that the pain of the recession and benefit of the rebound are not equally distributed. The inequality of wealth, income, education, access to technology, healthcare and affordable housing is a well-known problem plaguing this economy, and a deeply unfortunate side-effect of the COVID-19 crisis is that these gaps have widened further. Unemployment across the economy skyrocketed a year ago, and the subsequent recovery has been uneven. The unemployment rate for workers with a college degree or higher, and who are often employed in information, financial or technology jobs in which remote working is easier, has fallen back to 3.8% as of February 2021. The unemployment rate for workers with a high school degree has also recovered, but only to 7.2%, and workers without a high school degree face a job market where unemployment still stands at 10.1%. In fact, in February the unemployment rate for workers with at least some college education fell, while the unemployment rate for workers without a college education rose.

Chart showing unemployment rates by educational attainment from 1/31/1992 to 2/28/2021. Latest figures include: No High School = 10.1%, High School = 7.2%, Some College = 5.9% and College = 3.8%.

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These patterns are reflected in racial inequity as well. Across all educational levels and age groups, the unemployment rate for white workers is 5.6% at present (February 2021), vs. 9.9% for Black workers. Asian unemployment, at 5.1%, is even lower. This is a subject for much deeper discussion in a different forum, but suffice it to note that a robust and durable recovery in the economy requires broader job creation and availability across the educational and racial spectrum.

A third economic risk arises from the potent combination of fiscal stimulus, monetary expansion and rising household savings. This is a textbook recipe for inflation, at least when consumer confidence improves and people start spending money again. There is at present little evidence that inflation is a problem in the American economy: The Consumer Price Index (CPI) rose a scant 1.7% year over year in February and hasn’t topped 2% at any point in the past year. Fixed income investors, however, are beginning to price future inflation into their buying decisions, driving up the yield on longer-dated government bonds in order to compensate for the risk of higher inflation in the future.

This graph shows the U.S. Treasury yield curve as of certain dates - December 31, 2019; December 31, 2020; and March 11, 2021. Although the very short end of the U.S. Treasury yield curve remains close to zero, in line with monetary policy, the yields on longer-dated bonds have risen back to pre-pandemic levels. The 30-year government bond yields 2.27% as of mid-March, compared to 1.65% at the beginning of the year.

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The move has been rather dramatic. Although the very short end of the U.S. Treasury yield curve remains close to zero, in line with monetary policy, the yields on longer-dated bonds have risen back to pre-pandemic levels. The 30-year government bond yields 2.27% as of mid-March, compared to 1.65% at the beginning of the year. This rise in yields is taking place despite the fact that the Federal Reserve continues to buy about $80 billion of Treasury securities each month (plus an additional $40 billion of mortgage-backed securities), exerting upward pressure on bond prices (and therefore downward pressure on yields).

We see these rising inflation expectations even more clearly in breakeven spreads. A breakeven spread is the difference in yield between a nominal U.S. Treasury bond and the Treasury Inflation-Protected Security (TIPS) with an equivalent maturity. The only difference between these two securities is who bears the risk of inflation: An investor in a nominal Treasury bond runs the risk of being repaid in dollars whose value has been reduced by inflation, whereas the principal of a TIPS is adjusted to reflect inflation, so the U.S. Treasury bears the inflation risk. The gap between these two yields – the “breakeven” at which they provide a comparable return to each other – is the aggregate market expectation of inflation over the life of the bond.

Chart showing 5- and 10-year breakeven spreads for U.S. Treasury from 1/1/2007 to 3/11/2021. At present, breakeven spreads are signaling that bond investors expect inflation to average 2.57% over the next five years and 2.28% over the next 10 years.

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At present, breakeven spreads are signaling that bond investors expect inflation to average 2.57% over the next five years and 2.28% over the next 10 years. There is nothing strictly predictable in these figures. As the graph illustrates, expectations fluctuate over time, sometimes dramatically. On an absolute basis, current expectations are not alarming: 2% to 3% inflation hardly poses a risk to the economy or financial markets. The trajectory of this outlook, though, is a little more worrisome. After a sharp bounce off the depressed lows of last spring, expectations over the next 10 years are higher than they have been since 2014, and the five-year breakeven spread hasn’t been this high since summer 2008.

This doesn’t mean that we are going to wake up one day and find that inflation has leapt to 5% or 6% overnight. While the cyclical effects of monetary policy, fiscal stimulus and household spending may be inflationary, the secular implications of technology and aging populations are deflationary. Furthermore, although the Federal Reserve has adjusted its inflationary approach to aim at an average of 2% inflation over time (as opposed to a ceiling), it nevertheless retains the ability to reverse course, wind down its balance sheet operations and raise interest rates in order to stifle future inflation. The big question over the next few years is how the Federal Reserve will respond to rising inflation. Will Fed Chairman Powell and his colleagues interpret more inflation as the natural, but transient, result of pent-up consumer demand, and therefore keep monetary policy easy to support the economy in the longer run? Or will the Fed proactively tighten monetary policy at the first sign of inflation in order to prevent the economy from overheating? As noted earlier, Powell has pledged to keep interest rates as low as needed, for as long as possible, even if inflation rises with the return of consumer confidence. Financial markets are taking him at his word. For now.

Investment Implications

Even a modest increase in inflation poses a risk to the objective of preserving wealth. After all, at the end of the day it’s not how much money you have that counts, but what you can buy with the money you have. Wealth is, in other words, an absolute concept. Money is simply a way of measuring wealth on any given day.

Readers are no doubt familiar with the miracle of compound interest – how a small amount of money, at even a modest interest rate, can compound into great wealth over time. No less an eminence than Albert Einstein referred to compounding as “the eighth wonder of the world,” and observed further that “he who understands it, earns it. He who doesn’t, pays it.” Einstein knew well the Newtonian principle that to every action there is an equal and opposite reaction. Inflation is the equal and opposite of compounding: It can cause great wealth, at even a modest rate of inflation, to diminish over time.

Chart showing the purchasing power of $100 at different inflation rates (4%, 6% and 10%) over time. Inflation has averaged around 2% for the past decade. At this rate, the dollar loses about 40% of its purchasing power over a 25-year period ($100 declines to $60.35). At 4% inflation, the loss rises to 64% ($100 declines to $36.04), and at 6% inflation, the dollar loses 79% of its purchasing power over the period ($100 declines to $21.29).

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Inflation has averaged around 2% for the past decade. At this rate, the dollar loses about 40% of its purchasing power over a 25-year period. At 4% inflation, the loss rises to 64%, and at 6% inflation, the dollar loses 79% of its purchasing power over the period. Small changes in the inflation rate have a big effect over time.

This is the single biggest threat confronting longer-term investors, almost regardless of the level of their wealth. Market and economic cycles will come and go (which is why they’re called cycles), the political power of parties will ebb and wane, interest rates will rise and fall, and taxes will be raised, and then cut, and then raised again. Thus it has always been. Inflation is the often-unheard background noise amidst all this cacophony. Like the proverbial frog in the pot of warm water that slowly heats to a boil, investors should recognize that inflation is heating up before it cooks their portfolio.

How should investors hedge their portfolios against inflation? First, through appropriate asset allocation. Each and every asset class plays a role in a portfolio, and we find that equities play the primary role of both preserving and growing value – in a real, inflation-adjusted sense – over time. This is not to deny the role of fixed income, only to place it within the overall context of what an investor needs her portfolio to do for her. To the extent that there are nearer-term liquidity needs, fixed income is a far better solution than equities. Fixed income typically has lower day-to-day price volatility, making it stable and available to meet spending needs, and if those needs are nearer term, then the longer-term risk of inflation isn’t so threatening.

This graph shows the performance of selected asset classes vs. inflation. The data is all pegged to a starting point of 100 on December 31, 1977, the earliest available observation for many of these data series. Since that starting point, the CPI index has risen to 422, an equivalent of 3.5% average inflation over this whole period. Equities have provided the most protection against inflation, hitting 4,159 at the end of the chart. Corporate bonds rose to 2,469, and Treasuries rose to 1,795. Gold and real estate have beaten inflation over the period analyzed – with their latest respective levels at 1,046 and 1,301 – but there are a few points at which both of these asset classes have lagged inflation.

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As the nearby graph illustrates, equities have provided a better hedge against inflation than other asset classes over time. The data in this graph is all pegged to a starting point of 100 on December 31, 1977, the earliest available observation for many of these data series. Since that starting point, the CPI index has risen to 422, an equivalent of 3.5% average inflation over this whole period. Gold and real estate have beaten inflation over the period analyzed, but there are a few points at which both of these asset classes have lagged inflation. Bonds – both Treasuries and corporates – have well outpaced inflation, but we need to remember that for most of this time bond yields were in a secular decline, creating capital gains in addition to the yield generated by the bonds. With interest rates at historically low levels, this dynamic will not recur to the same extent going forward, and bond returns will likely be lower in an environment of either stable or rising rates.

Equities over this period have compounded at an annualized rate of 9.3%, or to a total index level of 4,159 on the graph, from an initial start of 100, well ahead of inflation and the other asset classes analyzed. As the graph makes clear, this return has come at the cost of higher volatility, but equities have clearly provided the best option for longer-term investors eager to protect their portfolios against the damage of even modest inflation.

In addition to asset allocation, we find further inflation protection by seeking to invest in the equities of companies with certain characteristics that give them pricing power and allow them to pass on to their customers the effects of a general rise in prices, or a specific rise in their own input costs. Companies with strong balance sheets and healthy free cash flow tend to have the financial flexibility to adapt to uncertain economic environments. Companies that sell essential products and services to loyal customers often enjoy the recurring and predictable revenues that brand loyalty offers, while granting them the ability to exploit that loyalty by hiking prices when needed. None of this makes a company or its stock price immune from market cycles or rising inflation, but it does offer an added layer of inflation protection on top of asset allocation.


In his 1926 book “The Silver Stallion,” James Branch Cabell observes: “The optimist proclaims that we live in the best of all possible worlds; and the pessimist fears this is true.” Economic optimists are rightly cheered by the triple prospect of government stimulus, low interest rates and a surge in household spending. This powerful combination promises to drive an acceleration in economic activity and corporate profitability as 2021 unfolds. Pessimists agree with this outlook, and then extend it to a logical conclusion that ends in rising deficits, debts and inflation. As Cabell’s witty and insightful bot mot implies, both can be right.

We readily acknowledge that concerns about rising inflation have been unrealized for a long time: A monthly inflation report hasn’t topped 4% since 2008. We are nevertheless reminded of Aesop’s fable about the shepherd boy who delights in tormenting his fellow townsfolk by crying wolf, in order to send them scurrying about in fright before realizing that there is no wolf. They eventually wise up to the scam and start ignoring the boy’s cries. That’s when the wolf shows up and eats the boy.

There is light at the end of the long tunnel of health and economic concerns that have weighed on investors for the past year. We are glad to turn the calendar on 2020 and look forward to a better, stronger and healthier 2021, while at the same time keeping a wary eye on the old threat of inflation that might return to complicate the objective of preserving and growing wealth.

References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.


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Coniderations for Managers

These product structures may be ideal for an asset manager who is managing active strategies and is wary of publishing their holdings daily. When considering whether these products are right for their firm, managers should ask themselves:

  • Which product structure is right for my strategy?
  • How will I price these products alongside my existing investment menu?
  • Should I seek to replicate existing strategies or launch something new?
  • Will broker/dealer platforms support these products?
  • What are the operational nuances that are unique to these products?
  • How will I need to adjust my distribution strategy to support these products?
  • How should I structure my capital markets team to support these products?


Asset managers should consider what strategies may work in this wrapper and how a proxy-basket, semi-transparent active offering could be added to their capabilities. BBH is ready to discuss these products in more detail and welcome the opportunity to engage with firms in deeper dialogue about this development.

Over the past 15 years, Brown Brothers Harriman (BBH) has partnered with more than 40 asset managers and sponsors to bring ETFs to market in the US, Europe, and Hong Kong. BBH has worked with all four proxy product sponsors and other third-party providers to design an operating model to service these products. 


On December 10, the SEC approved new proxy-based, semi-transparent active ETF structures from Natixis/New York Stock Exchange (NYSE), T.Rowe Price, Fidelity, and Blue Tractor Group. While each of the products is unique, they all use “proxy baskets” to avoid the possibility that investors will use disclosed information about an ETF’s holdings to front run the strategy. These structures may provide a compelling option for active managers to enter the ETF market without revealing their “secret sauce.” In this edition of Exchange Thoughts, we break down the different features of these active structures.

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Up Next

Market and Portfolio Update Q1 2021

BBH Chief Investment Officer Suzanne Brenner and Head of Investment Research Tom Martin review the markets and provide an update on our current portfolio positioning and priorities.
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Up Next

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