A once in a century pandemic, a shuttered global economy, gut-wrenching uncertainty and fear … led to portfolio gains for diversified investors in 2020! While stocks proved to be a roller-coaster ride, bonds fulfilled their typical defensive role, and then some.
Everything in 2020 seemed to be “unprecedented”, including the monetary/fiscal response. Central banks and governments around the world flooded the system with support, providing a lifeline to investors. The chart below compares the Fed’s reactions to the pandemic crisis and the 2008 great recession. The response has been bold and massive. In addition to this, significant government fiscal support programs targeted towards individuals and businesses continue to provide additional support. Indeed, “unprecedented” seems appropriate.
Source: St Louis Fed, J.P. Morgan Asset Management. December 14, 2020.
ECONOMIC RECOVERY TO CONTINUE, BUT IT LIKELY WON’T BE SMOOTH
Consumers – Unlike a typical recession, where household balance sheets are damaged (if not impaired), the opposite has occurred. Reduced spending, rising home prices and fiscal stimulus have helped push household net wealth higher. In the US, household savings will provide the fuel for pent-up spending demand which remains very supportive of economic recovery.
Canada’s leveraged consumer started in a weaker position; but with fiscal support for employees amounting to more than twice the amount of wages lost at the height of the pandemic, the Canadian consumer has been provided ample support as well. In addition, the labor market has been recovering much quicker than in a typical recession (unemployment rates have recouped approximately 2/3rds of losses), as businesses benefit from previously mentioned financial aid and the economy benefits from lower interest rates.
Businesses – With the vaccination process underway, albeit haphazardly, we expect the health crisis to abate over the next few quarters. Economies will come off the current restrictions and businesses will need to restock abnormally low inventories (not just toilet paper and Lysol wipes). Recent economic manufacturing surveys in Canada and the US are at multi-year highs and new orders continue to rise. This will lead to additional employment gains and increased capital spending. Economic activity and corporate profitability will continue to improve.
Governments – Debt levels exploded on the back of aggressive crisis spending, while lockdowns resulted in large revenue shortfalls. Government spending in the post-pandemic economy may be constrained relative to past recoveries, but so far developed economies have been able to borrow without repercussion. For example, US debt as a percent of GDP is projected to reach World War II levels (record highs) by the end of this year, yet interest rates are near record lows. Policymakers are betting that the support they’ve put in place will drive GDP growth significantly into the future to help with the elevated debt levels. The massive accumulation of global debt will come into the spotlight over the next few years. The historic magnitude of recent government spending likely means it can’t simply be passed onto the next generation. Closer to home, this will likely manifest in the form of higher taxes, with higher individual tax rates, capital gains tax and additional sales tax all on the table. Dire economies are facing more drastic situations. This is perhaps best highlighted by the abrupt introduction of a wealth tax in Argentina, as the country grapples to fund its COVID-19 response and deal with heightened inflation.
While we expect economic improvement through 2021, we also anticipate it to be bumpy. In addition to fragile economies being pushed to the brink, many countries are back in near-lockdown mode as they were in the beginning of 2020. We should anticipate this to show up in weaker economic data over the next few months. Although we have a vaccine, we seem incredibly unprepared to administer it. This needs to be addressed. Lastly, with new strains of the virus mutating, there is the possibility that the vaccine may not be as effective as originally understood.
While stock markets have recovered dramatically, the risk for investors is that they have gotten ahead of themselves. The fear and uncertainty that were priced into markets in Q1/Q2 last year have all but vanished. Instead, markets now reflect a high degree of optimism and the sense that policymakers can and will continue to support markets no matter how bad things get.
This “can’t lose” attitude is leading to speculative extremes. A good illustration of this is the mania developing in the initial public offering (IPO) market. Many money-losing companies are going public and seeing their share prices double and triple on their first days, as investors trip over themselves to get in on the action. Given the incredible valuations being awarded to new IPO’s, we expect to see more companies going public to cash in. The Renaissance World IPO Index tracks the performance of companies that have recently gone public. It’s up over 150% this year!
Source: FTSE, InvesTech Research December 18, 2020
A CHANGE IN MARKET LEADERSHIP IS UNDERWAY
We believe the unwinding of COVID will provide the catalyst for a significant change in market leadership going forward. The winning themes of 2020 have likely seen their best relative performance days. In the recent past, market leadership has been very focused on growth stocks, future innovation stories, thematic investments (gold, bitcoin), the US market, large caps etc. These trends were then exacerbated by the COVID sell-off, leaving these stocks extremely highly valued. Many strong businesses in the broad global economy have seen their share prices continue to languish. With economies set to open and the collapse in bond yields behind us, the stage is set for significant earnings and multiple recovery for solid but neglected businesses.
The vaccine announcements in November gave us a glimpse of this rotation. A much wider group of businesses and industries participated in the market rally than we have seen for quite some time. In addition, the businesses with the lowest relative market valuations moved dramatically. We have previously discussed the extreme divergence between growth and value stocks over the past decade. To top it off, this past twelve months was one of the worst annual periods for the value style on record. Investor patience has certainly been tested, but now is not the time to jump ship. We’d argue the opposite, as it is often these types of amplified events that occur on the brink of a major sea change.
PORTFOLIO POSITIONING
Our equity portfolios continue to display both quality and value attributes. Balance sheets and dividend yields are healthy. We are invested in resilient, proven business franchises, to which the market is starting to pay attention. This is evidenced by the strong performance we witnessed in our equity mandates in the fourth quarter. Our bond portfolio remains defensively positioned and well balanced between corporates for yield and governments for defensiveness and liquidity. With yields remaining as low as they are, few fixed income investments are competing with our equity holdings to warrant selling down equities in our balanced portfolios. We expect our consistent approach to risk-managed investing to be well rewarded in the years ahead.
