View From The Top

Swans, cake and elephants

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

View from the very top: The polarisation towards an almost unqualified bullish consensus has been rapid. We sit in the broadly optimistic camp but also caution that when the facts change, investors will also have to adapt. This was the key lesson from 2020. Sure, many of the building blocks are in place for the ‘everything rally’ (or fear of missing out) to dominate the narrative in 2021, but the recovery will almost certainly be non-linear and setbacks will undoubtedly occur along the way. Investors should also consider whether it will be possible to see easy policy and a vaccine-inspired restoration of growth without a major increase in rates. Only time will tell. Watch for a possible rise in inflation (expectations) and position appropriately. We continue to advocate a barbell approach with an emphasis on diversification and a preference for truly active and differentiated strategies.

Asset Allocation:

• Equities: This remains our preferred asset class for now, particularly when contrasting valuations relative to credit. With a strong rebound in earnings (against easy comparatives) likely for much of 2021, this should lend further support. Given the performance of certain areas of the market over the past year, some mean reversion is certainly possible. Value has consistently underperformed growth as a style and may see increasing investor interest over the coming twelve months. We prefer to stick with a barbell approach and believe stock pickers should continue to prosper. It will be important to act opportunistically and we see areas such as US small caps and selected emerging market equities being attractive.

• Fixed Income/ Credit: Despite a significant recovery in equity and credit markets over the last year, there has been no major increase in developed world bond yields. The ongoing constraint on such yields remains low inflation (for now). More broadly, credit is constrained by yields being close to near all-time lows. Over $18tr of global debt is currently negative yielding, up from $8tr in March 2020 (per Bloomberg), hence record issuance at the lower-quality end of the spectrum. Our caution here remains over the potential deterioration in credit quality. Invest only selectively.
• FX: Even if increasingly consensual, we see good reasons why the US Dollar should weaken further from current levels, particularly under an economic recovery scenario where the rest of the world expands at a faster rate than the US, albeit from a lower base. We would expect Emerging Market currencies to benefit at the expense of the US Dollar.
• Gold: The recent pullback in gold creates a clear opportunity in our view. The asset remains not only a very good diversifier, but also a low-cost portfolio hedge against unforeseen risks. Even if real rates have recently become less negative, we believe current levels still provide a structural support for gold.
• Alternative Assets:  We see a clear role for such assets in portfolios and are attracted to them owing to their diversification benefits, income generating potential and the protection they would offer in the event of higher inflation. We expect infrastructure assets to benefit from a likely increase in fiscal stimulus spend. Elsewhere, we see selected opportunities for business models with strong balance sheets such as seniors’ housing or logistics REITS.

Black swans do exist. This was our key take-away from 2020. This time last year, no commentator (to our knowledge) foresaw that an outbreak of a hitherto unknown virus traced to a wet market in Wuhan would have provoked – in the space of three months – the deepest and fastest global recession since 1929. The speed with which policymakers, scientists and frontline health workers dealt with this challenge is worthy of applause and the global outlook certainly looks markedly less uncertain than it did in March 2020. However, to make this observation is not the same thing as to state definitively that the boom in almost all risk assets will endure throughout 2021. We think there is a very good chance that this could be the case, but also caution against complacency and wish to remind readers of the possibility of other ‘unknown unknowns’ disrupting this seemingly roseate outlook.

It has certainly become clear that the traditional business cycle playbook does not apply. After all, almost every conventional economic norm was broken in 2020 as evidenced by the speed of both the decline and the subsequent recovery. There is no doubt that we are in a very different situation to the 2008/2009 recession. This time around there is no major deleveraging to manage, nor is there a declining growth trend to overcome – simply as a result of the unprecedented (at least in the modern era) level of collaboration between fiscal and monetary authorities.

The Central Bank ‘put’ has admittedly existed for some time, but this has now been broadened into the notion of ‘doing whatever it takes’; a cover-all term which would seem to include not only supporting financial institutions but also effectively inflating share prices and even smoothing volatility. Now add into the mix the massive stimulus programmes that are in the process of being disbursed by governments. The EU approved a €2.2tr package in December while America looks set to allocate a further $900bn in stimulus spend. This latter sum follows the $2.1tr of state funds released in April. Consider also that the pending appointment of Janet Yellen – a former Fed Governor – to the role of US Treasury Secretary is likely to be supportive to the doing-what-it-takes narrative.

Against this background, a ‘new consensus’ of almost uncritical optimism seems to have been building post the US Election and following the announcement of multiple vaccines. Bulls are in the ascendency for now. This has translated into what might generously be called an ‘everything rally’ or, less charitably, a fear of missing out. The numbers back up such a contention. November saw the largest-ever one-month flow into equities (per the International Institute of Finance; figures for December have not yet been released). Overall,  2020 was a banner year for issuance. Not only did proceeds from initial public offerings (IPOs) exceed 2019 levels by more than 65%, but total global capital markets issuance surpassed $11tr in 2020. For context, this was over three times the level achieved in 1999 and more than 25% higher than 2007’s peak (data from Renaissance Capital and Refinitiv respectively).

While we are encouraged by macro data, we are somewhat concerned just how quickly and readily such a positive world view – or, put another way, such a polarisation towards an almost unqualified bullish consensus – has been adopted. The risk in such an approach is that it potentially dismisses (any) other possible scenarios. Black swans, as we said earlier, do exist. Of course, not fighting the Fed (or Central Banks in general) has worked in the past, and so may work well in 2021; it’s just a matter of being mindful.

The macro data has, admittedly, been highly encouraging. The US, Japan and Eurozone saw rebounds in their third quarter 2020 GDP of 33.1%, 22.9% and 12.5% respectively, albeit from a low base. We also note that manufacturing and service sector output surveys continue to be positive, surpassing expectations. When the CEO of Toll Brothers (a large US home builder) says that “we are currently experiencing the strongest housing market I have seen in thirty years” – a message from the company’s last quarterly earnings call – it probably says that economies are strongly firing on multiple cylinders.

Much of this good news, is of course, now priced in. The forecasts from almost all the major investment banks call for at least 5% GDP growth globally in 2021. Meanwhile, the latest Bank of America Merrill Lynch investor survey shows that expectations are at their most optimistic in three years, with institutions’ cash levels at their lowest in seven. Meanwhile, countries around the world are locking down again. It would be complacent to assume that re-openings happen seamlessly. With winter beginning in the northern hemisphere, things may well get worse before they get better again. It would also seem both logical and prudent for corporates to be appropriately cautious on the outlook at the time of their fourth-quarter earnings in January/February.

Another spike in cases would be a sobering reality check. 2020 proved the lesson that when the facts changed, investors had to. Even if programmes have now begun, vaccine rollouts will not happen overnight and the logistical complexity of implementing such programmes at scale should not be under-estimated. The vaccine has never been, and will never be a panacea, particularly when not everyone even wishes to take it. How the world deals with the emergence of potential new strains of the virus also remains to be seen.

It therefore seems reasonable to assume three things. First, growth won’t be linear throughout 2021. Next, there will be ongoing regional and sectoral differences. Finally, the coming year will mark an incomplete recovery – since GDP will unlikely surpass pre-pandemic levels. Furthermore, if promised stimulus packages prove insufficient and/or are deployed inefficiently with delays, then growth may falter. Also, someone will have to pick up the tab, at some stage. Total global debt to GDP is set to end 2020 at 432%, up from 380% a year prior (per the International Institute of Finance).

The latter concern is unlikely to be a problem for 2021 (particularly since this metaphoric can has been constantly kicked further down the road). The ultimate question for investors is whether it will be possible for them to have their cake and eat it. This English idiom pertains to the notion of enjoying the best of all worlds. Put another way, will it be possible to see easy policy and a vaccine-inspired restoration of growth without a major increase in rates? To deploy one final metaphor, inflation is perhaps the biggest elephant in the room.

Only time will tell what the correct answer to the above question is. The debate between inflation-deniers and inflationists has been ongoing for quite some time. The former have data on their side, while the latter have, arguably, cried wolf too many times. Sure, inflation expectations are at their highest in eighteen months in the US and their most elevated in ten in the Eurozone, but from a very low base. The messaging from Central Banks has been quite clear on the matter: they are willing to tolerate some inflation and worry more about deflation at present. However, it’s easy to make such a claim in the absence of any notable signs of inflation. Perhaps the biggest problem is that we have all become so accustomed to a lack of inflation over the last forty years that it has become difficult to price/model/comprehend or even conceive of – choose your  preferred verb. Remember what we said about swans earlier. To the extent investors can, they should attempt to prepare for the unexpected. Wishing all readers the best for 2021.

Alex Gunz, Fund Manager, Heptagon Capital