13 January 2021
Returns in 2020 of 16% from global developed world equities, 18% from emerging markets, and 10% from global government bonds mask the enormous turmoil wrought by the coronavirus pandemic and the scale and depth of its economic, financial and human damage: an exogenous shock with global reach which was not on radar screens a year ago and matched in the past 100 years only by world war.
Behind the headline figures is a year of extraordinary volatility, with a sudden and dramatic collapse of markets as the pandemic spread rapidly beyond China, and an equally sudden recovery triggered by fiscal and monetary support on a scale never before seen.
There was huge volatility too between and within markets; without the phenomenal performance of the digital winners from the pandemic and the behavioural changes triggered, aggregate equity market returns would be very different: value stocks, largely reflecting the pandemic losers such as energy, financials, real estate, hospitality and tourism, were down over the year, despite a rally of 19% in the final 2 months following the news of vaccine success and, to a lesser extent, Biden’s election as US President. At a regional level the differing extent of the economic damage from covid together with the proportion of pandemic winners in stock markets produced substantial differences in performance.
The US returned 18% in the year, dominated by the FAANGs and other tech stocks, and east Asian markets also performed well as they were seen to bring the pandemic under control more effectively than elsewhere, whereas Europe struggled with more damaging economic impacts from the pandemic, including a worrying second wave later in the year, as well as higher exposure to value stocks.
Europe ex UK managed only a marginal gain in euro terms in the year while the UK market was down 13%, negatively impacted too by the intense uncertainty, at least until Christmas Eve, surrounding the shape of the future trading relationship with the EU. In emerging markets the bulk of returns came from China, up 30%, which recovered from the pandemic more rapidly and successfully than elsewhere; emerging markets in SE Asia, Europe and Latin America suffered double digit falls.
Bond markets were driven by a substantial fall in both nominal and real yields as policy rates were cut to near or below zero across the developed world and real rates fell to new lows, well into negative territory. Returns for the year were led by the higher yielding bond markets, with the US and UK +8-9%, while in the euro area the peripheral markets significantly outperformed German bonds as spreads tightened in the face of substantial ECB buying.
However, most of the returns on government bonds came in the first half of the year when economies slumped into deep recession. As recovery took hold and positive news of vaccine developments emerged in the final weeks of the year, together with the Biden win which increased the prospects for a substantial fiscal spending programme in coming years, the yield on 10 year US Treasuries rose from a low of 0.5% in early August to 0.9% by year end.
Credit markets fell sharply as the pandemic took hold in Q1 but recovered well in the face of massive injections of liquidity, falling interest rates and a hunt for yield. As the ‘reflation trade’ emerged later in the year credit spreads narrowed to historical lows, and investment grade, high yield and emerging market bonds outperformed government bonds, recovering most of their underperformance earlier in the year.
However, the stand-out performance in the year in the fixed income sector was a 39% return from convertible bonds, a highly effective asset to own in multi-asset portfolios, providing participation in equity market upside along with downside protection from the bond component.
Inflation expectations, having fallen sharply as economies collapsed during the first wave of the pandemic, picked up during the second half of the year as prospects for economic recovery improved while central banks continued to pursue an aggressive monetary easing programme across the world, fuelling concerns among investors that inflation could pick up in the medium term.
A combination of intense uncertainty, zero interest rates, a weak dollar, falling by 13% on a trade weighted basis from its March peak to the year end, and historically low rates on other defensive assets, led to the gold price moving to all-time highs of over $2000 by August. Growing confidence in recovery and vaccine development saw a period of consolidation in gold, which ended the year at $1900, still one of the best asset class returns in 2020 of 25%, proving its worth as an excellent portfolio diversifier.
As we enter the new year the deep uncertainties which beset 2020 have lifted substantially.
Back in March, the end of the pandemic was nowhere in sight, few had expectations of a vaccine for several years or indeed ever, many expected a chaotic end to the UK’s transition period with the EU in December, and fears about the outcome of the US Presidential election were surfacing. Although second waves and mutations of coronavirus are ravaging many parts of the world, particularly the powerhouse developed economies of the northern hemisphere, the extraordinary achievement of scientists in developing effective vaccines in record time have been a game changer. There is now not just light at the end of the tunnel, but the exit is in full sight.
Risks remain, notably around the effectiveness of vaccines against the new emerging strains of the virus and the logistical challenges of mass vaccination programmes, but there is now a clear path to exiting the restrictions which have inflicted immense damage on economies and especially certain sectors, on business and consumer confidence, and on employment. The first quarter of the year will be very tough and could well result in double-dip recessions in parts of Europe and North America, but thereafter the beginnings of a return to near-normality should be underway and the conditions are set for a strong recovery: release of pent-up consumer demand, renewed business investment, refocus of fiscal spending on stimulus and growth rather than support for businesses and people most damaged by the pandemic, and continuing ultra-loose monetary policy.
While the pandemic has rightly dominated the narrative in the past year, and the vaccine success was by far the most important development in Q4, the news on the US election and the UK-EU Brexit deal were also very significant and lift heavy clouds that have been holding back confidence. The end of the chaotic Trump era and return of stability, predictability and reliability in US leadership have been widely welcomed, and the much-feared contested election and break down of law and order have been largely avoided: the constitution has prevailed.
Biden’s success is likely to result in larger fiscal packages to promote growth, along with some tax rises, but the more extreme elements of the Democrat’s policy agenda are unlikely to be implemented given the narrowness of the result, especially in the Senate. Stricter regulations for ‘big tech’ are now more likely but there will be a thawing of international relationships, especially with US allies, a return to the post WWII international order, and renewed focus on multi-lateralism.
Trade related uncertainty will be much reduced, although relations with China will be one of Biden’s greatest challenges beyond the pandemic, with a return to pre-Trump status quo ante highly unlikely given the bi-partisan support for a more hawkish approach to China.
In classic EU style, the Brexit negotiations came down to the wire, but in the event PM Johnson confounded the doomsayers by delivering a trade deal free of tariffs and quotas while restoring sovereignty and taking the UK out of the jurisdiction of the European Court of Justice.
His manifesto commitment of ‘getting Brexit done’ has been fulfilled and given the UK much-needed good news and a boost to confidence after four and a half years of post-referendum uncertainty. In the PM’s own words ‘the old and vexed question of Britain’s political relations with Europe’ have been resolved; aside from a small minority of hard core ‘rejoiners’ the country has moved on.
There are challenges ahead as the UK adjusts to its new trading arrangements with its biggest partner, and there is much to be resolved around service industries, most importantly the key finance sector, but there is no question that the deal removes intense uncertainty and brings new opportunities globally. Already the UK has agreed trade deals with 62 countries and is in advanced discussions with the biggest prize, the US. Together with the UK’s early approval and roll-out of vaccines, the Brexit deal brings much greater optimism, the foundation for a robust recovery, and is likely to herald the end of the long period of underperformance of the UK equity market.
Despite the human and economic distress being inflicted by covid on large parts of the world, we therefore enter 2021 with considerable optimism. The vaccines will enable a gradual lifting of social mobility and other economically damaging restrictions, and in time will restore near-normality. The first quarter of the year will be challenging but beyond that there are grounds for expecting a very strong rebound in activity. Both 2021 and 2022 should be an unusually strong period of global growth, underpinning a huge recovery in corporate earnings. Furthermore, the biggest of the immediate worries, Brexit and the US Presidency, have been removed and political issues should feature much less among investor concerns.
At the same time, policy measures will be supportive. Central banks across the world are committed to maintaining substantial asset purchases and interest rates at or very close to the lower effective bound, close to or below zero. There is no prospect of increases in policy rates in 2021, and probably for a considerable time beyond. The importance of the Fed’s decision in late 2020 to move to average inflation targeting should not be under-estimated; it means that the Fed is prepared to let the economy ‘run hot’ for a period to achieve its inflation target and underpins the case for ‘lower-for-longer’. The ECB is currently reviewing its own policy and is likely to move to a similar approach during 2021.
The enormous emergency fiscal support provided by many governments to offset the damage wrought by the pandemic will taper off during the year as the virus retreats, but we see no appetite for, or return to, fiscal austerity. With borrowing rates at or close to all-time lows and negative in real terms, the case for increased levels of capital spending is difficult to deny. Spending will shift to growth enhancing measures, covering infrastructure, communications and green energy/climate change initiatives.
The time to focus on paying down the debt mountains built up during the pandemic will come, but not yet as recovery has yet to take firm hold and the global economy is too fragile. During this period an increasing alignment between fiscal and monetary policies is likely, whether by design or otherwise. The test for its durability will surely come if inflation begins to pick up; although this is highly unlikely in the year ahead given the current state of the global economy and over-capacity, it is a risk not to be dismissed.
Against this background, we believe that equities will make further progress and provide the bulk of returns in 2021. We are mindful of the strong gains made in recent weeks and high valuations in some parts of the market but see a rotation into undervalued sectors with the largest recovery potential: value stocks should perform well. Growth stocks play an important part in portfolio construction but high valuations and risks of big tech coming under much greater regulatory scrutiny are likely to hold back returns after a stellar period of performance. Generally, we see corporate earnings driving markets in 2021 rather than higher valuations. We believe it is unlikely that bond yields will fall from current levels; more likely we see some steepening of yield curves as the year progresses and economies recover strongly.
Other than in their role as the ultimate defensive investment, there are therefore few opportunities in safe haven government bonds; we continue to focus our fixed income investments on credit and emerging market debt to take advantage of the higher yields and some modest spread tightening during the strong recovery phase ahead. Finally, we believe it is important to retain protection against the risks and uncertainties that inevitably lie ahead. Gold continues to play a role and while it is unlikely to repeat its performance of 2020 it is a proven store of value during both deflationary and inflationary periods - -risks which might presently seem remote but which would have substantial impact.
Our optimism should be tempered by those risks and uncertainties. The roll-out and efficacy of the vaccines, the duration of protection and their impact on transmission; the risk of policy errors, which could be particularly damaging given the extent to which economies and markets have come to rely on central banks and governments for support during the pandemic; the huge public debt overhang which could be disruptive in funding markets; the risks of long term scarring from the pandemic; longer term inflationary concerns; the uncertain evolution of the key US-China relationship; all point to the likelihood of bumps along the way as we navigate through what we hope and expect to be the final stages of the pandemic.
As ever, true portfolio diversification, including defensive assets and a range of equity styles, will be the best way to mitigate these risks and enhance returns, and most importantly it will be vital to stay invested; the highly promising prospects for 2021 should reward investors and we see setbacks in the weeks ahead as a good buying opportunity.
G A Owen
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