January 2021 - Monthly House Views
Glass Half Full
The year 2020 is now behind us, but it is a period indelibly etched into our collective memories. We entered the year cantering towards the eleventh year of a bull market, a long rally seemingly impervious to its own impermanence. Of course, it all came to a shuddering halt as the breadth of the Coronavirus pandemic began to register. The drawdown (peak-to-trough loss) in global equity markets on 23-March – what proved to be the nadir – was about -40%, a stunning collapse that occurred in less than a month. At the time, it appeared that the 50% drawdowns that occurred in 2000 and 2008 would be eclipsed in a matter of weeks. The 1929 drawdown of 80%, the worst of all time, also loomed on the horizon.
What came next was as surprising as the initial plunge. Despite widespread lockdowns, near-total economic stasis, surging unemployment and a terrible toll in illness and death, the second quarter witnessed a powerful rally in risk assets, with global equities rising by 17.7%; by the end of 2020, global equities rallied by 60% from the trough. With the benefit of hindsight, we can synthesise the underpinnings of this rally into two distinct phases.
First, governments and central banks unleashed hitherto unthinkable levels of fiscal spending and monetary stimulus to help stabilise economies and provide liquidity to financial markets, backstopping wages and cashflows across entire economies. Once again, in hindsight, it is clear it was “enough” to underpin the powerful fillip in markets. The long-term consequences remain to be seen – government debt levels are at post-World War II highs and central banks have inadvertently become enormous players in financial markets. Nonetheless, huge government intervention was called for to prevent a Great Depression-style collapse, and governments delivered.
Second, there were critical wins in the battle against the disease. Death rates among Covid-19 patients dropped dramatically (i.e. from 25-30% in the spring to 3-8% in the Autumn) due to lessons learned by doctors during the first wave and the development of better treatment protocols using steroid drugs and non-drug interventions. This allowed economies to tentatively re-open. It was then followed by the real gamechanger of vaccine announcements in November, giving hope of a decisive and definitive end to the nightmare.
Vaccines notwithstanding, we are not out of the woods in terms of human suffering and economic dislocation – a dark winter looms before vaccination efforts begin to bear fruit. As we step into 2021, investors again find themselves facing stunning juxtapositions.
On one hand, we are in the tightest grip thus far of the coronavirus pandemic, with thousands of deaths each day and major economies in various states of lockdown. On the other, human ingenuity and modern technology have never shone brighter, with the fastest ever development of vaccines being followed by the largest mass inoculations ever conducted.
On one hand, last year’s economic slump due to the COVID-19 pandemic is being followed by subdued recovery. Activity in manufacturing has improved markedly from mid-2020 lows, but the services sector – by far more important to advanced economies – remains tepid. On the other, global markets – with equities at all-time highs and rates close to record lows – have chosen to look through the darkness to the light at the end of the tunnel when vaccine-led normality returns.
On one hand, early-January witnessed a mob storm the US Capitol, for many an emblem of the liberal democratic order that has presided over global peace and prosperity since World War II. Clearly, populist distrust of “elites” remains palpable. On the other, major geopolitical tensions appear on the wane – the Biden presidency should bring more predictable policies on trade, and long-standing issues like Brexit are now largely in the rear-view mirror.
On balance, we believe risk assets – particularly equities – remain compelling, supported by strong momentum and a recovering global economy. Valuations are challenging but tolerable given low rates and extreme overvaluation in fixed income markets. Risks, as always, remain: sentiment is increasingly bullish and we cannot rule out vaccine-resistant virus mutations or similar setbacks, leading to further lockdowns. Nonetheless, we believe the case for increased risk-taking is well supported.
As always, we are guided by the four pillars of our investment process:
- Economic regime: Our Leading Economic Macro Indicator (LEMI) suggests the global economy is in a state of recovery,which is favourable for risk-taking; we may even be on the cusp of expansion. Admittedly, the path of economic activity is highly uncertain and largely dependent on the ongoing fight against the Covid-19 pandemic – it is possible that renewed lockdowns cause a reversal back into a regime of “contraction”. Nonetheless, the risk of this has materially lessened with the mass deployment of viable vaccines, which scientific advice suggests are equally effective on known variants of the coronavirus.
- Valuations: Valuations for equities – the largest source of risk and return in most strategies – remain challenging in absolute terms. However, with global interest rates near zero, there is a case for a higher than usual tolerance to valuations (i.e. future cash flows are discounted by less). Moreover, the emergence of a vaccine – which can lead to normalised economic activity – is likely to be supportive of raised corporate earnings, which will serve to curtail valuations (all else being equal). Moreover, valuations for equities when compared with government bonds remain robust with the latter providing negative returns once adjusted for inflation. The case for government bonds is eroded further given the limited protection they are likely to provide from the current low yields.
- Momentum: Global equities are in positive momentum on the ten-month moving average metric that we favour. This is supportive of increasing exposure to the asset class.
- Sentiment: Of the indicators we follow, most, such as the trade-weighted US dollar and global equity fund flows, imply increased bullishness. However, they are not in overbought territory, which would cause us to be more circumspect on risk-taking. We continue to monitor sentiment closely.
We believe the case for increased risk taking is well supported given a strengthening economic backdrop, strong momentum and still tolerable valuations. However, we are cognisant of downside catalysts. These include vaccine-resistant coronavirus mutations, logistical setbacks in mass inoculations or a less supportive monetary and fiscal policy backdrop. Therefore, we continue to hold significant safety assets as a form of risk mitigation – these include gold and low-volatility, defensive alternatives (e.g. hedge funds).
As ever, we are constantly monitoring markets. Should conditions change, particularly with the economic regime, or signals from our valuation, momentum or sentiment framework, we will adjust our asset allocation accordingly.