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Investment Outlook January 2021

14th January, 2021

Introduction

The buoyant mood in equity markets, so evident in 2020, has spilled over into the New Year, driven by vaccine rollouts, hopes of increased stimulus in the US and rock-bottom interest rates. Equity market valuations remain elevated but are no higher than they were in June as earnings expectations rose in tandem with the market.

 

Figure 1: Earnings recovery continues

Figure 1

MSCI World Index – Earnings Expectations Next 12 Months. Source: Bloomberg.

This rally began following coordinated monetary and fiscal support on an unprecedented scale in response to the global pandemic. A combination of liquidity injections/backstops and direct payments to individuals and businesses has supported economies and financial markets around the world. There are few signs that this support will wane during 2021.

The double act

The coordinated support has been exemplified in the US where the Federal Reserve (“Fed”) has worked with the US Treasury department to get as much liquidity as needed into financial markets and to fund the sharp increase in US government borrowing. In these endeavours, Fed Chair Jerome Powell was at the forefront of the effort to underwrite the financial system when he committed the Fed to purchasing a wide range of assets in order to support a financial system under strain from the pandemic. This promise to support the financial system is vast in scale and scope.

As markets have recovered and investors look for clues as to the direction of Fed policy, Powell’s position is that the Fed is in no hurry to turn off the liquidity taps, even if inflation were to hit the central bank’s 2% target. This is encouraging for both debt and equity investors in 2021 and is keeping US bond yields in a narrow range, notwithstanding the Democrat “blue wave”.

When her nomination is approved by the Senate later this month, Janet Yellen will become the first woman to lead the US Treasury. As a former head of the Federal Reserve, Ms Yellen is expected to work closely with her successor Jerome Powell to alleviate the pressures from the pandemic. In the past, Ms Yellen has spoken of the “devastating” impact of unemployment on households, and was generally regarded as “dovish” during her tenure at the Fed. The combination of Yellen and Powell at the heart of the US financial system bodes well for markets in the year ahead. Liquidity, it seems, will remain abundant in 2021.

Winners and losers

The disparity in performance between equity market sectors in 2020 is remarkable. Sectors such as industrials, financials and energy produced double-digit negative returns as investors sought to avoid exposure to the economic cycle. At the same time, technology and consumer discretionary performed strongly. The overall positive performance at index level was driven by these winners.

On the day Pfizer/BioNTech announced the results of the vaccine trial, there was a sharp rotation out of the Covid-winners into sectors that had lagged and would benefit from a vaccine-related economic recovery. That move has lost momentum since the third-wave lockdowns started. The Democrats’ control of the Senate has given economically exposed stocks a boost in the New Year on hopes of increased stimulus and concerns about higher regulation and taxes on large tech companies.

At DGFM, we focus on selecting quality stocks based on our four pillars approach: profitability, persistence, protection and people. During 2020, the persistence pillar drove the outperformance of our quality factor. Investors rewarded companies that could sustain profitability during the pandemic. Technology and certain internet-related stocks benefited most from this phenomenon.

The people pillar, which ranks stocks based on capital returned to shareholders, lagged the other three for most of the year as it has more cyclical exposure. In the final quarter, this pillar outperformed as the news of successful vaccine trials raised hopes that the economic recovery would gain momentum.

It remains to be seen whether our people pillar will continue to outperform, but an economic recovery could only be said to be fully discounted in equity markets once economically exposed stocks regain some performance after a dismal 2020.

Financial repression

While equity and bond markets appear to be giving contradictory messages regarding the likelihood of an economic recovery, we believe this is entirely due to the actions of central banks. Global bond markets produced a positive return of 4.9% in 2020. All of this return was made in the early months of the year as bond yields collapsed in response to the spread of Covid-19. Yields have remained in a tight range since April as the weight of money from quantitative easing programmes (whereby central banks print money to buy bonds) continues to support prices. The effect is most pronounced in Europe, where the ECB’s programme is larger relative to the total bond market size.

The vaccine rollouts and the expectation of recovery should be pushing yields higher but governments and central banks need to control the level of interest rates due to the increasing debt levels worldwide. It is likely that bond yields will rise somewhat from here if the recovery gains momentum but not enough to cause alarm in financial markets.

If volatility returns and equity markets come under renewed pressure, bonds will provide some diversification as yields fall, but not to the same extent as in the past.

Conclusion

Many of the geopolitical risks we were concerned about a year ago have abated: a Brexit deal is done and relations between the US and its major trading partners are likely to improve under a Biden administration. There were grounds for optimism regarding monetary policy back then, and that remains the case for 2021.

Without doubt, some things have changed forever. For example, trends in technology adoption have accelerated since Covid-19. The performance of many of 2020’s winners was well earned. Many of last year’s losers may find 2021 to be equally difficult if new technology continues to enable disruptors in many sectors. We believe our investment process will continue to identify winners and losers in this transition.

We are long-term investors but are often asked for short-term forecasts. The range of possible outturns for 2021 is vast. A mutation of the coronavirus that renders the current vaccines ineffective is one nightmare scenario. On the other hand, the pent-up demand that has been building during lockdowns could result in a 1920s-style spending spree that drives economic growth and higher company earnings.

In the short term, equity markets are likely to focus on the efficacy of vaccine rollouts and the Biden agenda. Both come with risk and opportunity and there may be bouts of volatility over the next few months. In an environment of abundant liquidity and low inflation, equities can make gains in 2021. The upside scope for bonds is limited in the medium term, but we don’t believe that central banks will tolerate a sharp increase in yields.

The current environment suits an active approach to investment. When building equity portfolios, we prefer to focus on investing in profitable companies that deliver consistent results in the long run and allocate capital wisely. That approach is expressed through our investment process which uses a quantamental* approach to identify quality companies with ESG integrated throughout the process.

 

*Our quantamental approach combines the freedom of judgement of fundamental investing with the bias-free objectivity of a quantitative model, and seeks to provide clients with the best of both investing worlds.

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