With the strengthening of the global economic rebound underway, we invite you to explore our insights into what may be in store for 2021.
While we have yet to leave all the horrible debris of 2020 behind us, 2021 is shaping up to be another positive year for equity markets. The reversal of relative performance across multiple asset classes should continue, in our view. The core rationale behind our outlook is the strengthening of the global economic rebound underway since the middle of last year. Relative valuations, performance differentials over the past several years, as well as continued fiscal and monetary policy support should contribute to the continuation of anticipated reversals. We expect the non-United States equity outperformance that started in earnest in November and the rotation toward value/cyclical versus growth to persist, if not accelerate. We also anticipate a better bid on inflation-participating assets, including commodities and commodity-producing equity markets.
The essential non-economic pillars behind the outlook include third-wave COVID-19 containment programs (given that we are somewhat less optimistic than the market appears to be on the progress of mass vaccination programs by the end of Q3), and an assumption that the United States dollar will continue its decline (consistent with non-United States economic growth acceleration and United States dollar overvaluation metrics).
As for timing, we expect robust economic growth acceleration in the second quarter. Our intermediate-term positivity is bolstered by the massive fiscal spending and central bank support thus far, which we see as likely to increase on any weakening of the economy or lack of revival of the service/lower wage components. An economic accelerator in the form of personal savings has been building in the economy due to the combination of COVID-19 lockdowns weighing on services expenditures and direct fiscal stimulus in the form of checks to consumers. Combined, these create the potential for a spending bonanza in the second half of 2021 and well into 2022 (EXHIBIT 1).
Americans sit on a growing pile of cash that may be spent once the vaccine is fully rolled out
EXHIBIT 1: UNITED STATES PERSONAL SAVINGS
united states personal savings pre-covid levels
Overall, we remain constructive on global equity markets but expect a correction of normal proportions in the next few months. After all, the never-ending stimulus news and dovish guidance from the Federal Reserve (Fed) are likely to subside. When they do, markets will be left to contemplate the high valuations that followed a run-up in equity prices of epic proportions. Our outlook assumes an absence of global macro events such as renewed trade wars, new pandemic concerns and geopolitical issues. We fully expect the direction of policy, particularly in the United States, to move toward a reinvigoration of the base of the economic pyramid, reviving lower income jobs and wages, and broadly benefiting the service component of the economy.
Global equity positioning
Portfolios are well positioned for the acceleration of global growth, with a modest overweight in equities overall, but with an emphasis on emerging markets as the main tool to capture that growth. We are rotating increasingly toward value/cyclical assets, particularly in the United States The backdrop for value/cyclical outperformance is as good as it has been for several years, driven by a number of factors. Realized economic growth has the potential to meaningfully outpace the economy’s trend growth, inflation is rising but still contained, nominal rates are rising but real rates are still negative, and the relative performance gap of value versus growth rivals that of the late 1990s (EXHIBIT 2).
Value stocks are historically cheap to growth stocks; the discount is likely to narrow
EXHIBIT 2: Next-Year P/E multiple discount, Russell 1000 Value vs. Growth
Next-Year P/E multiple discount, Russell 1000 Value vs. Growth
Our value tilt in Europe, which should have benefited from an acceleration of growth post the “phase 1” trade agreement between the United States and China, was a large detractor through the first quarter of 2020 as the pandemic eviscerated the more economically sensitive parts of the global economy. Excluding the first quarter of 2020, our European value managers delivered significant excess returns, with some generating as much as 30% over their benchmarks. In portfolios for our international clients, the value tilt was less pronounced; underlying managers had a more quality growth orientation to cushion them in the March downturn. Subsequently, we made a deliberate but gradual shift to more cyclical parts of the European and Japanese markets. Overall, the equity allocation contributed positive alpha to the returns of our international clients in 2020.
While multiple expansion was by far the biggest component of positive equity returns in 2020, we expect the earnings outlook to be the core driver of returns over the next 12 to 24 months. In the very near term, there could be some giveback in relative performance if markets rise rapidly, but we believe value has more room to run as global economies continue to recover.
Active versus passive execution
As stated in previous issues of CIO Pulse, we are long-term agnostic as to active versus passive execution, but tilt in either direction as market conditions dictate. At this point, we expect that the era of FAAMG1 dominance has ended for now. That view reflects a number of idiosyncratic risks and high multiples on potentially slowing growth as these businesses continue to mature. The wider dispersion of returns in a market not dominated by a handful of mega cap stocks presents an opportunity for skillful active managers to add alpha in a more meaningful way (EXHIBIT 3).
The market has struggled to compete with the mega cap growth stocks, but their multiples have some downside
Exhibit 3: Price-to-earnings ratio of top 10 and remaining stocks in the S&P 500, next 12 months
Price-to-earnings ratio of top 10 and remaining stocks in the S&P 500, next 12 months
Manager performance was mixed; more value-oriented managers underperformed while higher-quality and growth-tilted managers tended to outperform. The changes we made to the manager roster this year added value (EXHIBIT 4). We cut a United States large cap core manager after noticing significant style drift, and added United States growth, Asia-ex Japan and China managers. We continue to search for managers with long-term and consistent track records for adding value through security selection and a competitive advantage in assessing business models. We are willing to accept wider than average tracking error for these types of strategies, and have the patience to look through two to three years of underperformance in pursuit of longer-term alpha profiles.
Our manager additions in 2020 have added value, both relative to their asset classes and specific benchmarks
EXHIBIT 4: Manager performance CHARTS , 2020 additions
Manager performance CHARTS , 2020 additions
Real asset attractiveness
Inflation expectations as measured by TIPS breakevens have risen recently indicating that, at least cyclically, inflation is percolating. Additionally, the Fed has made clear that it will tolerate an inflation overshoot in order to accomplish average inflation at its long-term target of 2%. With the backdrop of an accelerating global economy, we expect that reflation beneficiaries, such as broad commodities, gold and gold miners and commodity-heavy economies such as Brazil, should experience better relative performance. These assets are generally underowned after an extended period of underperformance, adding to the upside potential as the post COVID-19 economic environment unfolds. We are looking to add marginally to these exposures on any weakness.
Considering all the macro factors impacting the economy and markets, portfolios maintain a balanced risk profile, with a roughly neutral fixed income allocation and a slight overweight in equities. Excluding our cash and near-cash positions, duration is neutral/slightly underweight at roughly six years (roughly seven years for international clients) and is likely to be reduced as growth accelerates into the second quarter. Our targets for the 10-year United States Treasury yield range from 1.35% to 1.65% depending on the trajectory of inflation. In 2020, TIPS outperformed the benchmark as investors anticipated a revival in economic activity. We expect further outperformance this year as above trend-line growth and a falling dollar nudge up inflation expectations (EXHIBIT 5). The active managers currently in the portfolio have exposures to the mortgage markets and investment grade securities that should add a modicum of additional yield to the fixed income portfolio. Both exposures have added positive excess return since the mid-year economic recovery.
Inflation forwards are breaking out, and they typically correlate strongly with bond yields
Exhibit 5: United States breakevens and government bond yields
United States breakevens and government bond yields
After two tough years of performance, what is the basis for better performance ahead?
After two materially disruptive global macroeconomic events (the global pandemic and the United States-China trade war) over the past two+ years, our approach—embracing risk over the long term to meet return objectives—has underperformed. That underperformance was primarily driven by an overweight to risk assets (specifically, our value-tilted managers and sector exposures combined with an underweight to fixed income duration) going into the greatest economic decline since the Great Depression. Today, the world looks materially different with vaccines and a distribution program at hand, fiscal and monetary support at unprecedented levels, and economic activity reviving quickly albeit with a first-quarter pause as the new wave of COVID-19 peaks. China today is past its pre-COVID-19 level of economic growth, and much of Asia is progressing convincingly toward complete recovery.
We expect to perform well over the course of the economic recovery, and have made several changes to bolster that expectation. We revised our manager roster while continuing to emphasize emerging markets and Asia generally as the core driver of equity performance. Our value tilts are increasing and fixed income duration remains underweight. Since the market bottom in late March of last year, portfolios have started to regain lost alpha.
The one notable detractor during the second half of 2020 was gold and especially gold miners, even though both the metal and miners were major positive contributors to our full-year performance. With a “risk-on” mentality sweeping markets, gold has had a very tough few months, hurting portfolio results. We continue to see gold as a portfolio bulwark against inflation, geopolitical events and a falling dollar. In terms of gold miners, after an elongated period of poor governance, the major miners have changed course and have produced results validating our preference for their positive cash flow, earnings and rising dividends over the metal itself. As of this writing, the largest United States miner, Newmont Mining (NEM), has just announced a significant stock repurchase program supporting our thesis and positive outlook for the group as a whole, though we acknowledge the considerable volatility inherent in mining equities.
Happy New Year and good health to all.
Overall, our portfolio aligns to expectations of above-trend global growth and easy policy
EXHIBIT 6: ASSET CLASS