Investment Matters

2020 wrap-up

2020. It has been a bizarre year, to say the least.

A variety of words could be used to describe the year in financial markets (“unprecedented” chief amongst them).

We look at the year through a series of charts and ponder what 2021 may hold.

121820IM01

Equity markets

121820IM02

While the recovery of the US market this year has been stunning, the dispersion in performance between equity markets internationally has been even more unusual.

The US market has performed strongly, buoyed by the NASDAQ leaders (Facebook, Amazon, Netflix, Google, Apple).

Comparatively, European markets have been weak, particularly the UK market, with uncertainty around coordinated fiscal stimulus and Brexit still looming.

We recently took the opportunity to decrease clients’ portfolio exposure to the US market and increase exposure to geographies where we see better value (“an international tilt”).

What is also worth noting the large disparity between the Australian and US market, likely due to the ASX’s exposure to less “new economy” and technology stocks.

121820IM03

Commodity markets

121820IM04

After a steep fall in March, we have seen commodity prices recover, with a combination of stronger global demand (particularly in) China and supply side issues across several commodities including Copper (+27% since mid-February) and Iron Ore (+69%).

Clients’ portfolios have benefited through an exposure to Mineral Resources (Iron Ore), BHP (Iron Ore) and Sandfire (Copper).

Gold (+21%) was a strong performer as interest rates declined, while carbon-intensive and transport reliant fossil fuels suffered, including oil (-22%) and coal.

We reduced clients’ exposure to oil and coal-related stocks over the year.

 

Interest and debt markets

We saw a sharp rise in yields in February as credit markets tumbled.

However, with unprecedented intervention from central banks (particularly the Federal Reserve) we have seen bond yields normalize and credit spreads contract even further.

121820IM08

Credit spreads have begun to fall again to record lows as investors look for yield in a lower-rate environment.

The low-interest rate environment has also seen the price investors are willing to pay for stocks rise as can be seen below. This, in combination with a recovering earnings outlook, has seen the market's P/E rise.

121820IM05

With interest rates beginning to rise, we continue to be weary of investing in “bond proxies” or companies whose value rely on an assumption of low interest rates.

Conversely, an improving economic outlook and rising interest rates should be positive for several stocks in the portfolio, including value stocks, financials, and resource companies.

 

Earnings expectations

After falling precipitously earning expectations have begun to rise with prospects of mass vaccinations in 2021.

The chart below plots the number of earnings upgrades relative to downgrades. As the market fell in February, we can see that the number of downgrades heavily outweighed the number of upgrades (a ratio <1), but as we have come out of the crisis this ratio is now firmly above 1, meaning the number of upgrades now comfortably outweigh downgrades.

Current expectations are for earnings to rise in 2021 by 10% on average from their 2020 lows, however, this may be conservative, as post-recession we have typically seen recoveries of a larger magnitude, such as in the GFC (+20%).

121820IM06

Value strikes back

Late in the year, we have also seen the disparity between “value” and “growth” stocks begin to close as investors begin to rotate back into cyclical companies and interest rates have headed higher.

Clients’ portfolios, which have a value bias, have benefited through this period, and outperformed by more than 2% over the month of November, benefiting from an exposure to NAB, ANZ as well as other value positions such as Boral, Platinum and Perpetual.

With the economic outlook improving, “value” stocks may continue to have legs in the new year.

121820IM07

Expectations, portfolio positioning and some unanswered questions

Leading into a new year there is always a balance to be struck between expecting trends which emerged in the previous 12 months to continue and positioning portfolios in anticipation of new trends.

With 2020 presenting such a stark point of dislocation, and the starting conditions prevailing in Australia provide the potential for a powerful rebound in activity, the trade-offs facing our portfolios are stark.

First a word of caution. Global coordinated success in deploying vaccines at a pace and scale that provides a rebound in the US and Europe together is not guaranteed. For this scenario and given the rapid rebound in equity prices, we retain moderate levels of cash and a conservative positioning in gold stocks.

Questions to be answered in 2021 include:
- Will enough people take the vaccine?
- What will the impact be on small business as stimulus measures roll-off?
- Will excess savings accumulated during COVID lead to a spending spree?
- What will the permanent changes in preferences be and how large an impact on certain markets (residential real estate, commercial real estate)?

There are no clear answers, however, a portfolio approach enables positioning towards companies that are favoured by various outcomes.

We currently favor the view that a sharp rebound in nominal growth (that is through prices or activity) is likely. This helps our conviction in retaining a value bias and lower exposure to high priced growth stocks.

We see an asymmetric risk to inflation (higher probability of a large positive surprise, than a large negative surprise). When the word inflation is mentioned some naturally recall the days of 5% plus inflation, wage spirals and dislocation. This isn't the inflation that we are referring to.

Rather simply the inflation that sees well-positioned companies, in strong industries, and often with existing networks or capital invested being able to pass on increases in underlying costs to customers.

In such circumstances, businesses are in a stronger position to reinvest in both existing and improved plant and equipment. In turn, they are more likely to capture for themselves gains in productivity and innovation.

Current inflation expectations are very low by historical standard and even a reversion to mean would be a surprise for the market. This would see slightly higher interest rates and a further move away from growth stocks towards value.

Factors that could lead to this inflation surprise include the huge levels of government support for industry and income and the elevated level of savings in the household sectors of many countries during COVID lockdown.

Other trends that we believe have been reinforced by 2020 experience included global commitments to infrastructure spending and fiscal support.

We look forward to providing you updates as Investment Matters returns next year (Friday the 29th of January 2021).