Our RtoR series is designed to help investors filter the noise in today’s markets to improve understanding and investment decisions
Markets are at or near all-time highs, anticipating bipartisan stimulus and rollout of multiple vaccines. With COVID infections spiking, is all the good news baked-in here, making for a difficult 2021?
Vaccines and stimulus are certainly catalysts, but we believe the investment playbook must be deeper and more dynamic than that. Larger forces are at play.
True, exiting 2020, we expect economic news to get worse before it gets better. Last April and May saw the worst of it, but we expect a challenging winter ahead as COVID spreads and states wrestle with social restrictions. Potential political brinksmanship over stimulus and the pending Senate race in Georgia might only add to volatility.
Still, we see cause for optimism for 2021. Consider:
- Unprecedented resources are being marshaled to develop vaccines, which we believe should achieve scale in distribution by summer or fall of next year. Adoption rates and successful trials are admittedly wildcards in that deployment.
- Economic recovery will take time, and several sectors will struggle, but vaccine and stimulus should uncover that earnings estimates for next year may be too low for healthy companies benefiting from recovery.
- Record amounts of cash are on the sidelines, on both corporate balance sheets and in wealthier consumers’ saving accounts. We expect this cash to be invested as economies heal.
Importantly, we doubt we have seen all the bad news of depressed demand on corporate balance sheets. But we do not believe the theme of “secular growth at any price” emerging over the past few years represents the best approach for long-term investors as we shift from containing the pandemic to rebuilding the economy.
NEW RISKS AND OPPORTUNITIES
We believe the massive stimulus of 2020 (and likely 2021 as well) in response to the pandemic has already set the stage for a new set of risks and opportunities for long-term investors, which are just now starting to play out.
We believe markets are already signaling the shift to a new regime to some extent. For example:
- STOCKS: Equity investors since early September have rewarded small stocks, companies potentially benefiting from recovery, and more diversified portfolios rather than biggest tech or quarantine winners. These stocks trade at discounts to their long-term opportunity.
- Between September 2 and December 4, small stocks and large value stocks are up over 19% and 10%, respectively, vs. the largest tech stocks’ 1.1%.
- We saw early signs of these opportunities in 2019, and they became more pronounced in 2020 with the pandemic. We have tilted client portfolios accordingly, within client risk tolerances.
- BOND YIELDS: Yields remain at historic lows, but the yield curve is at its steepest point in nearly three years.
- This steepening either reflects an improved outlook for growth (good for equity investors) or growing concerns over rising deficits (inflation, which could be a challenge if it is high).
- Either way, we see a risk to long-term bonds if yields continue to rise (i.e., current prices fall). For this reason, we keep maturities shorter in our bond portfolios.
- INFLATION: Inflation expectations have increased to an implied 1.9% in the Treasury market.
- We continue to see inflation as a wildcard in 2021 but a risk longer term.
- Stimulus should continue to pump historic liquidity into the monetary system (inflationary)…
- … but many key industries remain well below capacity (disinflationary).
In contrast to the past few years, we believe select international markets offer attractive long-term opportunity for patient investors. In particular, we favor allocations to Canada and select countries in Continental Europe, while we have below average exposure to the UK and Japan, where margins, fundamentals, and market momentum appear relatively less attractive.
REMINDER: BALANCING OFFENSE AND DEFENSE
If 2021 is a concern—and there will inevitably be negative surprises, perhaps in timing of stimulus, deployment of vaccine, weakness in demand, etc.—we rely on the defensive allocations in client portfolios (fixed income, as described above) to help address volatility, in keeping with client risk tolerance. In contrast, the equity allocation serves to drive longer-term portfolio growth, incorporating risk in a diversified, balanced way.
SIGNS OF EXCESSIVE OPTIMISM?
We’ll close by noting where we see excessive optimism.
To reiterate, the pandemic itself is not over. Big challenges remain to rebuilding damaged industries, major pockets of dampened demand, and local and national economies.
Yet some sectors have “popped”, highlighting spots of excessive optimism in equity markets.
Over the past four weeks, industries decimated by the pandemic—hotels, resorts, cruise lines, airlines, and casinos—are broadly up over 25%, compared to the S&P 500’s 5.6% (Exhibit at end).
These stocks have some of the worst fundamentals currently and projected. By our analysis, most stocks in this group have little earnings this year and next, poor cash flow generation, and weak growth dynamics. In particular, many airlines, cruise lines, and casinos have high-risk balance sheets, with heavy debt burdens.
We believe these stocks carry excess risk. Any negative surprises, and we don’t think these stocks have the fundamentals to support current pricing.
Markets are forward-looking by about six months, in our view. They are already looking beyond much of the bad news associated with mounting COVID infections, counting on vaccines and stimulus. Successful investing requires a deeper discipline, however.
That discipline requires a longer-term view that recognizes meaningful dislocations, objectivity in rebalancing portfolios toward them, and patience to navigate through the noise.
The disruption caused by the pandemic and the implications of historic stimulus are just now starting to play out. The better playbook currently for investors is one focused on recovery for global risk-assets (offense), mindful of the risks of inflation, and balanced with appropriate defense to navigate the inevitable surprises.
EXHIBIT: Performance of Selected Industries