Global markets have come a long way since the initial pandemic-induced declines, and we're continuing to see opportunities in this quickly evolving new economy.
The global economy and markets have come a long way since the initial pandemic-induced declines in March of this year. Monetary support from the world’s central banks and massive fiscal policy responses have helped drive one of the sharpest snapbacks in modern economic history through the third quarter. And now, because the COVID-19 recession was not accelerated by typical end-of-cycle excesses in consumption and supply conditions, but rather by an exogenous, non-economic shock, the rebound should continue relatively swiftly (all else being equal).
Production and manufacturing industries have reclaimed most of the economic ground lost since the global health crisis began. The most recent Purchasing Managers’ Indices (PMIs) for China, the U.S., and Germany show the manufacturing sector in strong expansion territory (Exhibit 1).
Manufacturing sectors in major countries are rebounding strongly from recent lows
Until recently, recovery for the services side of the global economy has been less robust. We anticipate this sector will experience a much slower rebound to pre-COVID-19 levels—at least until mass distribution of vaccines creates a “coast is clear” mentality that motivates consumers to resume expenditures at an early-2020 pace. Indeed, we expect economic momentum to decelerate from Q4 2020 through the next several quarters. Still, the pace will likely be above trend line growth as global economies continue to recover. Should this outlook materialize, we expect markets to continue their upward path at a much more moderate pace and, importantly, anticipate a rotation in market leadership away from the secular growth and technology-enabled sectors toward the value and cyclical components of the market.
In the short term
We are not in the practice of positioning portfolios for two-month forward outcomes. Still, uncertainty around a number of potentially material events keeps us balanced in our positioning. Those events include a new and potentially significant surge in COVID-19 cases, a highly contentious U.S. election, risk of a breakdown in Brexit negotiations, lack of further fiscal stimulus in the U.S. (or elsewhere) and the possibility of other October surprises. Together, these unknowns support our barbell approach: pairing defensive technology/growth positions with some value and cyclical allocations. Over the past month, U.S. and global markets generally have teetered between technology/growth and value/cyclical outperformance. We believe this tug of war is likely to break in favor of value/cyclicality once there is clarity around the above issues and greater certainty that the global economic recovery will continue.
Intermediate-term outlook and positioning
We’ve previously argued that the best way to view the world’s outlook is through the lens of China’s (and much of North Asia’s) experience in bending the virus curve and economically rebounding to pre-COVID-19 levels. Given expectations that U.S. and global growth will continue at an above-trend rate, albeit slowing from a torrid pace, we believe keeping a healthy allocation to risk assets across sectors and geographies makes the most sense for long-term investors with a return hurdle.
Consistent with our pro-growth economic outlook, we are well-positioned to participate in what we expect (at least over the next few quarters) will be a rising market with outperformance by non-U.S. markets and increasingly with a value/cyclical bias. As we have positioned portfolios this way for the past two years, the question is: what’s different now?
Our answer: headwinds from a trade war (as in 2018-2019) or a pandemic (assuming relief beyond the first half of 2021) should be less of an issue. What’s more, with monetary and, increasingly, fiscal policy, becoming accommodative relative to depressed levels of stimulus and with the growth and technology sectors arguably fully valued, we should finally get a rebound in activity that may catalyze a growth-to-value rotation of significance. Even before considering potential antitrust headwinds for “big tech,” growth vs. value relative performance differentials and valuation spreads over the past 10 years appear stretched and due for a reversion (Exhibit 2).
Relative performance of value vs. growth has reached multi-decade lows
Importantly, value and value-tilted managers should finally have their day in the sun, even as we have consolidated the active value allocations to the EAFE/European parts of the portfolio.
We have used multiple levers to embed exposure to value and cyclicality in the portfolio over the past couple of years, including a regional overweight to Asia ex-Japan and a sector tilt to global mining. Another tool we could use is flexibility with respect to market capitalization, and we observe a large relative performance gap in U.S. mid/small cap (SMID) equity vs. large cap equity. The Russell 2000 Index has underperformed the S&P 500 by nearly 30% over the last two years and could potentially revert, given a better absolute level of economic activity and accelerating economic growth. Should the large capitalization NASDAQ stocks take a pause, the outperformance of small cap and mid cap vs. large cap stocks could be considerable over the course of 2021.
The active management industry has seen some of the worst relative performance trends—regardless of geography, style or capitalization—in many years, which has weighed on the portfolio. However, we believe conditions contributing to this industry’s overwhelming underperformance are in the process of reversing. For example, we believe we are unlikely to see a continuation of the one-sided outperformance of FAANGM1 stocks relative to the majority of S&P 500 issues, which have a negative return on the year.
In the meantime, we have made numerous changes to our manager roster and have, on average, moved from approximately 60% active about two years ago to over 70% passive today.2 We have eliminated managers with meaningful style drift. But we have retained certain managers with shorter-term (trailing 1-2 years) underperformance, because we believe style has been a primary impediment to recent performance and we remain positive about their long-term alpha potential. We embrace tracking error in our managers, as it is usually the raw material for potential long-term outperformance, even if it may result in shorter-term underperformance.
For the most part, we are likely to retain our existing passive/active mix and unlikely to introduce new managers into the portfolio at this juncture. Instead, we will rely more on tactical, passive implementation at the regional, sector and capitalization levels to add alpha as market volatility and fundamentals evolve.
Gold: Our largest tactical call
Gold has been in the process of correcting since August, after peaking at approximately $2,075/ounce. Our allocation to gold and gold miners has hurt performance over the past two months as the key drivers of gold performance—real interest rates and the U.S. dollar—reversed their year-to-date trend.
Our expectation is that real rates will not move up meaningfully over the next few months as the Federal Reserve (Fed) pins rates lower for longer. We also see inflation expectations as firmly anchored for the time being. The USD still appears vulnerable to further sell-off with global (ex-U.S.) economies picking up speed and Fed interest rate policy providing little room for foreign investors to earn a higher yield net of hedging costs.
Meanwhile, the gold miner governance story remains very powerful. Leverage is at a multi-decade low; capex is being maintained (for the most part) below cash flow generation; dividends are being raised; and non-value-accretive M&A activity is noticeably lower than at a similar time in past gold price cycles, even as gold resource discovery remains challenging. Ultimately, we own gold mining stocks to take advantage of a rise in the price of gold and, just as importantly, for the cash flow, earnings and dividends well-governed companies can generate in an upcycle for the metal.
It remains to be seen whether the price of gold follows the same trajectory as it experienced in the 2004-12 cycle. But we believe gold prices have likely yet to peak, given that deficit spending, debt monetization and acceptance of Modern Monetary Theory (MMT) hold sway.
We expect the global economy to regain its past economic cycle highs in the second half of 2021, after two demand-destructive episodes over the past two years. The economic trajectory we anticipate will favor non-U.S. equity markets with a strong but relatively short period of value outperformance over the next several quarters. We currently maintain a full fixed income allocation, augmented by a healthy allocation to gold and gold miners because we are clearly in uncharted waters in terms of fiscal and monetary programs. Longer term, we will continue to find ways of investing in the quickly evolving new economy, even as we hold today a meaningful allocation to the Nasdaq 100 and a growth manager within the U.S. equity allocation.