Overcoming the natural instinct to sell in 2021 (afr.com)

There are always compelling reasons why not to buy equities.  Fortunately, they are nearly always proven to be wrong.

But after what was a truly astonishing year in 2020 where equity markets fell precipitously in February and March only to rebound strongly on the back of coordinated global stimulus and the rapid development of Covid-19 vaccines, investors are rightly asking themselves is it time to take some profits and regroup.

The laundry list of economic and market risks providing the backdrop for 2021 are unusually confronting.

While economies have generally passed the worst of the economic damage from the Covid-19 lockdowns, infection rates and death tolls are accelerating in most countries and many developed markets are expected to experience very soft economic growth in the first two quarters of 2021 as new lockdowns are instituted.  The vaccine roll outs are progressing at a relatively slow pace due to the sheer scale of the logistical exercise.  The new US administration is expected to take power shortly and there remains uncertainty to the approach they will take on many issues, including recent trade tensions and border disputes.  Escalating cyber-attacks remain a concern globally.  The monetary policy response of printing money is debasing the real value of currencies and the global fiscal response in 2020 has built on a legacy of huge budget deficits and accumulating public sector debt obligations.

Equity markets are clearly vulnerable to a pull back.  Valuations are stretched and a lot of the tailwinds that have boosted equity returns over the past 40 years are unlikely to be repeated next year – including lower discount rates, margin expansion, corporate tax cuts and share buybacks.

However, the reality is that bear markets are rare.  Over the past 75 years, bear markets have occurred only 18 per cent of the time, meaning returns on average were positive 82 per cent of the time.  Financial market history has taught us that while cheap valuation is a useful signal for overweighting equities, expensive valuation alone is not a signal to underweight equities.

On most metrics, equities are currently in the top decile of valuation ranges.  When equities have historically got to this extreme valuation level, the average 5 year forward equity return drops close to zero.  While this should obviously raise some concerns, this average return has historically masked a significant dispersion in actual outcomes.  The larger negative return experiences have most often been associated with late cycle imbalances and euphoria, followed by tighter policy and slowing economic activity.  The positive outcomes on the other hand have occurred when growth continues to surprise on the upside.

What is clear in 2021 is that monetary and fiscal policy will continue to support the post pandemic recovery.  Large budget deficits are baked into the economic landscape.  Central banks across the globe have reinforced their steadfastness to underpin growth and allow activity to run hotter than they normally would consider appropriate.  In August last year, the US Federal Reserve explicitly shifted to an average inflation target through the cycle for that very purpose.

It is important to remember that the recession of 2020 was not caused by imbalances in the economy but the health response to the pandemic.  Economic indicators across the globe are showing that activity is bouncing back sharply, and it is important to remember there is a strong correlation between growth and equity returns.  In the US, equities have a positive year in 87 per cent of the cases where the US economy is expanding.

While governments have stepped in to fill the gap in economic activity – what is still unclear is the damage that has been done in the private sector and particularly the earnings of listed companies.  Earnings ultimately drive share prices.  Changes to insolvency laws and interest payment holidays have masked the hit to private sector profitability.  However, consensus forecasts for US corporate earnings, which tend to lag the actual recovery, have earnings growing in the order of 24 per cent in 2021.

So, in an environment of improving economic growth and rebounding corporate earnings, the biggest endogenous risk to another solid year in equity returns is a surprise surge in bond yields, perhaps driven by a rebound in inflation or more worryingly driven by a loss of confidence in Governments’ solvency.  While the latter is probably an issue for a much later day, rising inflation is a more pressing risk in 2021. In 1994, the mere threat of rising inflationary expectations was enough to cause a dramatic sell off in bonds and a 10 per cent correction in equity markets.

But a major uplift in inflation appears unlikely.  Anaemic wages growth is unlikely to reverse quickly and the deflationary forces of new productive technology are likely to keep broad based inflation in check.  While some prices may firm up in COVID-19 sensitive sectors, they are unlikely to result in persistent increases in the rate of change of prices that would worry central banks.

So, while 2021 is likely to be another positive year for global risk assets, this does not mean that markets will go up in a straight line.  It will be important for investors to use the full range of tools available in their portfolio construction arsenal to actively navigate this environment.  This will include diversifying across geographies and actively considering currencies in a world of significant money creation.  

The $A has rebounded strongly this year driven by strong commodity prices, particularly the price of iron ore which is approaching US$180 per tonne.  The last time iron ore prices were close to this current level, the $A was trading at around US$1.10.  While there may be some further upside in the $A, the economic circumstances now are very different to 2011, particularly the collapse in the Australian cash rate differential with other economies.

This strength in the $A is giving investors a terrific opportunity to diversify their holdings into offshore markets, particularly Asian markets with higher structural growth rates or developed markets in selective names in technology hardware, health care, energy, and diversified financials.  We would prefer reasonably priced cyclicals such as consumer durables and those linked to the infrastructure spend rather than pure deep value names despite their recent strength.  Gold has had a strong run but performs better in falling real rate markets which is unlikely to be repeated this year. Bulk commodities and metals should continue to perform well in 2021.

More than most years, 2021 will be year where investors will need to stress test their portfolios to understand the range of possible outcomes and correlations between assets, including understanding the impact on private assets and other illiquid investments in real time.  While 2021 will not be without its challenges, in all likelihood equity markets will find a way to finish the year at higher levels.  Investors just need to put aside their natural instinct to sell.