World Economic and Market Outlook – 2021 A Year of Living Dangerously
Last year, 2020, was one where market commentators saw how difficult both longer-term, and even shorter-term forecasting is. The approach taken in these Outlook pieces try to take a longer-term view of structural thematic change in the global economy and the investment implications of these. We have always believed that despite the market noise, investment is a risk management exercise and that especially at times of uncertainty investors need to analyse markets in terms of the three market risk drivers. The first of these is economic fundamentals, the second valuation, and the third is shorter term in nature looking at market sentiment.
Looking at the first of these markets have front run the quickening recovery in global economic activity that became evident in the second half of the year and have remained strong despite a weakening of activity, especially in the non-Asia/Pacific service sector which started in the latter part of the fourth quarter as the Northern Hemisphere experienced a second or third wave of Covid-19. With further enforced lock downs and restrictions on activity this slowdown will accelerate in the first quarter of the year. Markets have been focused on prospects for recovery in the second half of 2021 and out into 2022. One important trend in the post GFC period has been that markets have increasingly discounted at an early stage either economic recovery or economic slowdown. The latter occurred with the weakness in markets during the second half of 2018 as concern grew that monetary tightening by the US Federal Reserve would slow economic activity significantly. The rally in markets in 2019 was driven by the Fed pivot on interest rates, and today investors do not wait for hard economic data to price in these changes. The speed of market moves demonstrated in 2020 by the fastest bear market selloff and then the shortest bear market period and rapid recovery demonstrates this which makes investing harder. It also means that unless an investor is an excellent short-term trader taking a longer-term view now on market prospects is often the most prudent course.
Today, equity markets look expensive on an absolute basis versus history under a variety of metrics, with both the forward PE and CAPE ratios in the top decile of historical data. The Shiller PE which looks at cyclically adjusted price earnings ratios, also known as the Cape, averages earnings over a 10 year period in an effort to estimate if stocks are over or under valued. Shiller himself has now acknowledged that in a world of zero interest rates, higher Cape ratios are justified and has developed a new measure, the excess Cape yield (ECY) which considers both equity valuations and interest rates. This actually indicates global equities are cheap and highly attractive relative to bonds, particularly in the UK, Europe, and Japan. The ECY estimates suggest inflation adjusted returns of about 5% for the next decade from the US stock market are plausible. As a result Shiller acknowledges that stock market valuations are not as absurd as some people think.
Whilst this might have investors heading for the exit, it is important to remember how the global economy and interest rate outlook are very different from even a decade ago. As Schiller has commented equity markets are not expensive on a relative basis compared to fixed interest securities. A lower interest or discount rate applied to company earnings increases the present value of these, thus justifying a higher PE ratio. Empirically one can see that periods of low interest rates and inflation are accompanied by higher PE multiples and these high multiples will come down as long as the expected economic recovery comes through. Furthermore, particularly in the S&P 500 Index, the high valuation reflects not only the concentrated nature of the market where the top five stocks account for nearly 25% of the Index, but also the sector breakdown with its high weighting to the fast growing technology sector. In contrast, the UK FTSE, which is often quoted as “cheap”, has a very different sector mix and arguably a much higher emphasis on sunset industries where top line, and even bottom line growth has been difficult to achieve over the last five years and where thematic trends suggest this will continue. More thought will be applied to the growth versus value dilemma later in this piece. Even high sentiment readings do not necessarily mean a sharp market setback is on the horizon as these can often unwind by markets moving broadly sideways for a period of time.
The most important factor justifying the high rating of the market is that economic fundamentals are broadly positive over the medium term. Whilst Covid had a devastating impact on certain sectors in the global economy, overall economic growth forecasts in the second half of last year were revised upwards and all the manufacturing PMI indices during December were not only above 50, but in most cases exceeded expectations. As commented in earlier articles manufacturing is easier to reboot than the service sector and within the service sector those companies not reliant on a high level of personal service have not only seen market share and volume growth, but a re-rating by the stock market as investors have realised that the long-term trends favouring these businesses have accelerated and market share gains will not be given back to any large degree.
Markets are focusing on the continuance of easy monetary policy and on the 14th January Fed Chair Jay Powell sought to stamp out fears that the Federal Reserve would begin winding down its asset purchases later this year saying the central bank was far from considering an exit from its ultra-loose monetary policies. Mr. Powell was speaking at a virtual event hosted by Princeton University and acknowledged the Fed had to be very careful in communicating about asset purchases because of the sensitivity amongst investors to the potential withdrawal of central bank support. He added one lesson of the Global Financial Crisis was to be careful and not to exit too early and that when the central bank had clear evidence of progress towards its goals and employment and inflation it would let the world know about its assets purchase policies. These assurances follow similar remarks from Richard Clarida, Vice Chairman, and Lael Brainard another Fed Governor and have underscored that the Fed is in no rush to pull back its support and wants to avoid a repeat of the “taper tantrum” that rattled markets in 2013. The publication that day (January 14) of discouraging data from the labour market including net job losses in December and a surprise surge in first time jobless claims have underlined a huge slack remaining in the labour market. It is also likely that the US Federal Reserve and Treasury will work closer with the appointment of previous Fed Chair Janet Yellen as US Treasury Secretary. Mr. Powell also emphasised the Fed would not overreact to a sudden jump in consumer prices this year as the economy rebounded from the pandemic as long as the view remained that these would only be temporary. He concluded by saying ‘when the time comes to raise interest rates we will certainly do that and that time by the way is no time soon.’
With the last two Senate seats in Georgia falling to the Democrats, the so-called ‘blue wave’ has now occurred to a greater degree than markets had assumed immediately post the election. Joe Biden has now proposed a new $1.9tn economic rescue plan which includes new direct payments to Americans, aid for State and local governments, and more funding for the Coronavirus pandemic response. The sad events on Capitol Hill will only make Republican opposition to these measures more difficult and a larger stimulus package than looked likely at the end of the year now seems likely. The second stage of Biden’s economic agenda is yet to be revealed but is likely to call for longer-term spending on infrastructure, green energy, and education which will be funded at least partially by higher taxes on both the wealthy and corporations. It is the latter which has the potential to cause at least some stock market concern.
Whilst Coronavirus case numbers, hospitalisations and deaths have increased significantly this year, markets as discussed continue to look further forward and the vaccine news overall remains positive. New approvals some time over the next quarter are expected from Johnson & Johnson (importantly a one shot vaccine) thus halving patient delivery time, together with Novavax, both of which have seen strong results from Stage 2 Trials and are in Stage 3 assessments today.
Devices, or in other words technology, have had a dramatic effect on the cost of producing goods and providing services. Some would view disruption as a modern-day word for competition, but there is no doubt that competitive forces of change have accelerated in many industries. This has been seen through the consumption of media which has moved away from print and traditional linear TV to online and streaming, together with the hollowing out of the retail sector in favour of online. Technology has unlocked capacity by taking out middlemen. There has been dis-intermediation or disruption to many industries and whilst it is still clearly at an early stage, this seems to have been accelerated by the COVID-19 pandemic. This supply side effect will continue to impart downward pressure on prices for many years to come.
Whilst clearly compared to past pandemics, governments have supplied high levels of fiscal stimulus to global economies, the effect of this outside of the widespread adoption of MMT (Modern Monetary Theory) is likely to be limited due to debt constraints and be transitory. However government role in economies is likely to increase. Analysis of previous pandemics suggests downward pressure on interest rates results and today this is combined with secular disinflationary forces, the 3D’s. This, if it occurs, will result in a lower discount rate applied to future corporate earnings which will benefit true growth companies.
These measures all point to a supportive background for equities at this time. The speed of economic normalisation will be an important factor, looking at the dichotomy and performance between value stocks and growth names with technology significantly outperforming energy and financials over the last 12 months. Even within this there are likely to be further distinctions between defensive and cyclical names and certainly in Q4, and especially November, growth defensives significantly lagged the market, with cyclical recovery doing well as was to be expected, but also many high growth names performed well in Q4 both in the technology and innovative healthcare sectors.
One point to note is that with extended valuations at present and extreme sentiment readings, any short-term disappointments to vaccine efficacy or roll-out could trigger a short but sharp stock market pullback, and whilst this is not the central case, needs to be borne in mind by investors. Historically, extended valuations and extreme sentiment readings have needed a catalyst to correct, but in today’s world of quant driven markets, if this did occur, it would likely be too fast for most investors to react after the event. The relative attractiveness of equities versus other asset classes continues to hinge on a continuation of low interest rates and inflation.
There were two factors behind the naming of this piece “The Year of Living Dangerously”. The first is that despite the positive news on vaccines, the emergence of second/third waves with increased levels of transmissibility means on the personal level everyone needs to stay ‘on guard’, as no one wants to emulate the soldiers who died just before the announcement of the First World War Armistice. The second concerns stock markets as the November vaccine news was rapidly priced in by markets to assume a strong economic rebound in 2021. New lockdowns and restrictions on movements, which are particularly concentrated in the Northern Hemisphere will reduce Q1 economic growth numbers and impact heavily on the already struggling service sector. Disruptions to supply chains could yet impact on manufacturing and there has already been a weakening in employment numbers in the States. The medical understanding of the biology of Covid-19 is increasing, but as yet is incomplete. Clearly, if issues arose about the effectiveness of the vaccine, particularly if the virus mutated more significantly than seen heretofore, or there was evidence of serious side effects from any of the vaccines in coming months, this would be viewed very negatively by markets.
Vaccines could be tweaked to adapt to mutations and the mRNA technology is particularly adaptable at this (some whole of virus vaccine treatments due to be approved this year are also expected to be well placed), but any consequent delay to the roll out would not be well received by equity markets. The chief concern at the moment involves the South African variant, although initial laboratory tests by Pfizer suggests its vaccine remains effective, although these results have yet to be peer reviewed, and test results from Moderna and Oxford AstraZeneca are still awaited, although there are no indications major problems are expected. Whilst these vaccines have been developed quickly, the Stage 3 tests were conducted with vigour and in fact Moderna, for example, skewed its Stage 3 trials to elements of the population deemed to be more vulnerable or less receptive to vaccines such as the elderly, those with underlying conditions and ethnic minorities. Due to the rigour of these testing regimes it seems unlikely serious adverse side effects on a widespread basis are likely.
There is always an interplay and overlap between secular and cyclical forces in an economy and investors have to contend with this. In the post GFC period powerful secular forces (ageing demographics, high debt levels, technology innovation and excess global savings) kept both growth and inflation at low levels. So called secular stagnation was a positive backdrop for equity markets, keeping interest rates at historically low levels and justifying the re-rating which has occurred of equities. Whilst both growth and inflation have been kept at low levels, some businesses have delivered strong revenue/profit growth in a low growth world and have, particularly over the last 12 months, seen their prospects re-appraised by markets and these names have provided strong leadership over the past decade. To date inflation has remained low despite the cyclical impulse from both low rates and quantitative easing by central banks. The key question for markets is how the anticipated cyclical upturn will unfold. If it is accompanied by limited inflationary pressures which remain constrained by secular forces with the spare capacity (especially in the labour market) caused by the severity of the Covid recession remaining in place there will be a relatively positive backdrop. This, however, is the first time both monetary and fiscal stimulus have been applied in large doses to the global economy, and today there is a rejection of the austerity policies which followed the Financial Crisis.
In a dramatic change from policies adopted post Financial Crisis fiscal orthodoxy has changed. Organisations such as the IMF and the OECD have told governments that with low interest rates seemingly here to stay, the cost of excessive borrowing is much lower for advanced economies than previously thought. This is especially important in an era where it is now generally accepted the positive impact from lower interest rates is played out and further rate cuts in the developed world will either be counterproductive or have limited impact, so there was a need for governments to take some of the burden off central banks in supporting crisis hit economies. Thus, in contrast to the previous decade, there is now a consensus view that the aim of balancing the budget can at least temporarily be dropped. In some ways this is akin to adopting Modern Monetary Theory. A paper from the Peterson Institute for International Economics which is headed by Adam Posen, argues for fiscal policy suitable for all seasons. While consensus policies can often be wrong, which is the view now on the calls/policies for fiscal orthodoxy post the Financial Crisis, most economists now believe that with the facts changing, policies need to adapt too. Inflation, economic growth, and interest rates failed to recover as anticipated after the Financial Crisis. Whilst there was a positive from keeping borrowing costs down, cutting spending also had a large negative impact. In today’s world governments can roll over their debt stock at reasonable interest rates. Thus whilst debt levels are high, as long as there is economic growth, bond market investors now take a longer term view on deficits and believe these can be successfully reduced over a longer time period than would have been deemed acceptable in the immediate post crisis period. The authors of the Peterson Institute paper, Peter Orszag, former Director of the Congressional Budget Office, Robert Rubin the Treasury Secretary who ran budget surpluses under Bill Clinton, and left wing Nobel Prize winner Joseph Stiglitz called for flexible economic policies including extending debt maturities and a greater role for automatic stabilisers such as unemployment benefits and high levels of infrastructure spending when growth falls.
Whilst inflationary prospects remain muted in the short term, markets do look ahead so perhaps it should not be too surprising that some of the strongest performing assets last year were US inflation linked bonds where inflation expectations fell to around 0.5% in the early days of the pandemic. There has now been a significant pick up in the forward level of inflation expectations looking at the five year/five year US number to around 2% and this has driven the strong returns delivered by US TIPs in 2020. This is despite the fact that, for example, US consumer price inflation was a measly 1.4% in December on an annualised basis. Wage growth remains weak and is likely to do so in an era of high levels of unemployment, certainly compared to what was forecast 12 months ago.
FT columnist Gillian Tett has argued that a rise in inflation could be a “Black Swan” event, something with a low probability but the potential for high impact on markets. Most investment portfolios today have been constructed on the belief that interest rates and inflation will stay low indefinitely and the Covid pandemic has further reinforced the lower for longer interest rate mentality. Thus, if anything did rock this consensus there would likely be a nasty market correction. There is a short term inflation risk if fiscal stimulus, particularly in the US hits the economy at the same time as the Covid-19 vaccines become more widely available. This has led some to forecast a surge in economic activity later this year with references to the ‘roaring twenties’. If this coincided with supply side bottle necks, and there have been indications this year of some supply chain difficulties in manufacturing, there is a potential for prices to jump in some areas. It is reassuring that Fed Chair J. Powell in his recent Princeton University address emphasised the Fed would not be panicked by a short-term uptick in inflation. Some economists argue that factors that kept inflation low in recent decades, globalisation and digitisation could shift adversely. The overwhelming evidence is that ageing demographics are disinflationary and whilst the number of workers in many countries including China could decline, there remains the potential for productivity gains and replacement of human labour through automation. Whilst pandemics in medieval times had a significant impact on the availability of labour and sometimes resulted in upward pressure on average wages, today the result is likely to be the opposite of this with many furloughed workers becoming unemployed, so helping keep a lid on wage inflation.
One unknown is that the Fed have now indicated that the 2% inflation target is not a ceiling but an average over the longer term. At present markets have been relaxed about this statement, but it is relatively easy for bond markets to remain calm when inflation in the US and around the world is nowhere near central bank targeted levels. After the now recognised mistake of over aggressive monetary tightening in 2018 there is likely to be pressure on the Fed to not countenance an early rise in interest rates this time round. Bill Dudley, former Head of the New York Fed, has related to Gillian Tett that this time round the Fed will be late raising rates by design. Whilst short term rates are likely to remain anchored at current levels, there could be upward pressure on longer dated bond yields if inflationary concerns came back to the market. This perhaps is the biggest threat to the current bull market, although not something that this author predicts will occur. The most recent comments by Fed Chair J. Powell suggests he is well aware of the threats of another taper tantrum and its impact, firstly on markets and then the global economy, so this is something investors need to watch rather than anticipate for now.
Central banks around the world might also extend the practice of yield curve control to 10 year government bonds in a similar way as has occurred in Japan. This could mitigate against any rise in long term interest rates and if inflation had also risen would result in nominal fixed interest securities offering a lower real (post inflation) return and some argue that lower real rates would justify a further decline in the discount rate applied to global equities.
Looking at economic fundamentals and the response to Covid-19 by both central banks, but particularly governments, it is clear that there are striking differences in terms of crisis policy responses with the abandonment by most governments of fiscal prudence and the adoption to an extent of the new orthodoxy of Modern Monetary Theory with a profound shift in conventional economic thinking re deficits and debt. The extent of the fiscal injection relative to the size of GDP has been of eye watering proportions. Bank of America estimate that the combined fiscal and monetary stimulus globally to date announced is US$22 trillion, nearly 25% of global GDP and the Biden administration are requesting a further injection of $1.9tn into the US economy alone. Furthermore, the bulk of this stimulus spending has yet to take effect in Europe and Japan.
As long as the vaccine roll out proceeds more or less as forecast, the extreme monetary and fiscal injections, when combined with the substantial build-up of personal savings as reflected in the very high savings rates for certain economies and certainly certain sections of this such as white collar workers, the middle classes and the elderly, raises the distinct prospect of a much more synchronised global upturn in economic activity than has previously occurred in the post GFC period. For certain sectors of the economy pent up demand will kick in. If this caused the lower for longer interest rate mentality of the market (the Goldilocks economy) to be questioned there could be negative consequences for equities and certainly some less cyclical parts of the market. In the States the Federal Reserve is already expecting a strong rebound in economic activity with forecast growth of 4.2% for 2021 and whilst increased levels of the Coronavirus today and lockdowns may cause these numbers to be pulled back, to some extent this may make the strong recovery an H2 2021/H1 2022 event.
Geopolitics had a significant influence on markets in 2018 as the US/China struggle came to impact markets through the Trade Wars. With the election of a new US President Elect there has been an uneasy truce, but the rivalry between China and the US is likely to remain important in 2021. Both the US and China believe, along with their populations, that each country is involved in an ideological struggle for, in the case of the US continued economic supremacy, and in the case of China a belief there is opposition in the West to it assuming its rightful place on the global stage. Under President Xi China has become more aggressive in its campaign for greater global dominance using both soft power and hints of hard power to look to achieve its aims. China has made no secret of its aim of an eventual Taiwan re-unification and the events in Hong Kong escalate the risks of tensions in this area. China has demonstrated in Hong Kong that its interpretation of one country two systems is fundamentally different from that of the West. There therefore remains the potential for some form of military conflict in the South China Seas and the Chinese will undoubtedly be assessing Biden’s commitment to defend Taiwan if required. The importance of Taiwan in the global economy is not well understood, but it is home to the semiconductor industry, producing components vital for this internet and e-commerce age. Taiwan has world leadership in this area and technological supremacy has already become a key battleground area for both China and the United States. China has historically played a long game, so may well decide making a more aggressive move against its neighbour is too risky at the current time, but tensions are likely to flare up from time to time. A Biden presidency could also unite western democracies against China in a way Trump did not.
On a more positive note, under the Biden Presidency, there is considerable scope for progress on climate change, and also some potential rehabilitation of the Iran nuclear deal.
GROWTH vs VALUE
The divergence between growth and value stocks was one of the chief market drivers of 2020 and positive vaccine announcements in November resulted in one of the most dramatic rotations from growth to value ever seen. Even that, however, was not straightforward and during the fourth quarter overall, and even in the month of November, it was defensive growth companies which lagged the market rally and whilst the dramatic share price gains of value cyclicals made the news many high growth equities in the technology space, together with Tesla and innovative healthcare/biotech companies actually delivered extremely strong returns to investors. Thus, positive vaccine announcements during the fourth quarter were the catalyst for what is referred to as the “reflation trade”. This broadly favoured value over growth stocks and if continuing suggests investors should underweight duration (interest rate sensitivity) together with the US currency.
Taking a wider perspective on the growth versus value debate, it is certainly true that growth stocks have outperformed for most of the last 13 years with only brief periods such as the second half of 2016 and the fourth Quarter of 2018, together with Q4 2020 when value delivered any form of meaningful outperformance and these periods to date have been short lived. Many older investors have been brought up on the principles of value investing which relies on mean reversion to deliver returns. Value investing has always relied on the use of valuation metrics, although these have evolved from PE ratios and price to book (net asset value) to take into account ratios such as price to sales, more importantly price to cashflow, and EBITDA metrics. Discounted cash flow or DCF methodologies are extensively used to ascertain if an individual stock has moved away from its fundamental long term value. Value investors look to try and take advantage of market despondency or in other words irrational pessimism by buying stocks at bargain basement prices.
Value investing has come to adopt a low valuation style highlighted by Benjamin Graham, although it has been adopted by some investors such as Warren Buffett to broaden the definition to include more highly rated stocks which still traded at fair prices. In markets today there is still a subset of value investors who adopt the Benjamin Graham approach and focus on low valuation metrics to the exclusion of most other stock characteristics. It is important to remember that low valuation parameters is not necessarily the same as being under-priced and many of these rigid valuation orientated investors have struggled to a significant degree in the post GFC period. In a world of rapid technological change and business innovation, many of these so-called value stocks have turned out to be value traps because they operate in structurally challenged businesses where companies with an operating weakness will find it more difficult to turn a business around.
One danger with looking rigidly at long term market metrics is that investment regimes and indeed economic fundamentals can change. Long in the tooth investors might remember when it was considered the norm for government bonds to yield less than equities as the latter were risky and then during the inflation prone 1970s and 1980s see a complete reversal of this thinking, with the belief that inflation risks made traditional fixed interest securities much less safe than they appeared to be, as the real rate of return in a higher inflation world was eroded over time. The post Financial Crisis period has seen once again a reversal of current thinking and now once again equities yield in excess of government bonds. The point of this discussion is that it is important to remember that investment is a dynamic and changing process and one of the reasons value investors may have delivered historically strong returns was the lack of research by even institutional investors into many listed companies. This author can remember personally utilising nearly all of his first post university pay check when employed at Royal Insurance to invest in a company called Stanley Leisure on a PE of 6x. Over the next few months the market realised this was a growth company rather than value play and the shares trebled. When moving on to cover the Irish stock market in the late eighties it was possible to meet reasonable businesses no investor had met for 2-3 years! Much of the success of legendary early emerging market investor Mark Mobius was that he was able to uncover (through extensive boots on the ground travel) and invest in stocks which were not followed by other traditional Western institutional investors. In other words, in the earlier days of value investing it was relatively easy to find growth companies priced by the market at bargain basement valuations, but this is something that is not really present today.
Thus, the investment world back when Benjamin Graham and Warren Buffett started out and adopted their value orientated philosophies was considerably different from the current one. In terms of the level of ‘competition’ investment management was not a trendy place to work, and in fact stockbroking (today called investment banking) was considered to be far more glamorous and lucrative than running funds. Reliable information was extremely hard to come by, with no computers, spreadsheets, or databases. The market was also dominated by private clients, which meant most institutional investors enjoyed a knowledge advantage or information edge, something that is no longer present in today’s world. Disclosure of price sensitive information by corporates to favoured institutional clients was not even a crime or misdemeanour. With few people searching in a disciplined manner for bargains, it was relatively easy to find them, but today markets have become far more efficient, perhaps helping to explain why many so called value opportunities have turned out to be value traps. It is only in the 2000’s with the broad adoption of the internet and explosion of the investment industry that this has changed and today most investors suffer from information overload rather than a dearth of views or statistics. Basic analytical concepts of today, like return on invested capital, competitive moats, and the importance of free cashflow rather than published earnings were not widely appreciated or understood.
As information became more broadly available and easily accessed huge money was spent on specialised data computer systems and out of this grew quant investing. Quant investment styles have struggled in recent years, perhaps the fact that there are so few observable market inefficiencies investing today on a basis of static formulas suggest it may be less profitable in the future than it was in the past. Performance of many of these strategies in recent years backs this up. In summary, for most stocks carrying a low valuation there is probably a good reason for this. There are also indications that successful investing today is reliant on superior judgements concerning qualitative rather than quantitative factors and understanding how the world is likely to unfold over the medium term, especially in terms of seismic shifts in how economies or corporates operate. (This is very different from short-term forecasting).
The disruption of traditional profit pools has also hit many so called value opportunities in the market place hard. Markets have become more global in nature and the internet has vastly increased the ultimate profit potential for many businesses due to both network and social effects. As was commented on in the December outlook “Looking Forward to a Better 2021” over the past decade the world has become more interconnected than ever, with the internet, mobile and social networks. Markets that were once independent have become interconnected with as a result more ‘winner takes most’ businesses with companies benefitting from network effects and/or social effects, both of which create bigger winners. Network effects refer to situations where the value of the product increases with more users. Social influence is different but also magnifies the inequality between winners and losers, although it does not explicitly change the value of the product or service to the user. Hence, social effects will be present in a broader set of businesses that are not associated with network effects. In an internet and technologically enabled age, it is easier for companies to produce a product or service without capacity limitations. Thus, there are less supply constraints for many products in today’s world, allowing potential for more sustained rapid revenue/profit growth than was achieved previously. The forward looking nature of today’s markets means it is now acceptable for companies to lose money in the short term in the pursuit of a large prize down the road if it seems realistically achievable. With the easier development and scaling of new products technology companies in particular have been able to further develop new avenues of growth such as for Amazon, its AWS division. In today’s world it seems the moats protecting winners have never been stronger and this can be seen in the sustained strong revenue growth achieved by many of today’s stock market leaders with little slowdown in contrast to the world of the 1960s when few companies could maintain a competitive advantage for long periods of time. Value investing does assume the economic principle of ‘perfect competition’ which no longer seems applicable or relevant in today’s world. In other words, today’s conditions means that profits will not always mean revert from either above or below the norm with perhaps banking being the business model which best demonstrates this, with today’s world of zero or negative rates and flat yield curves, meaning traditional levels of return on equity can no longer be generated.
Today’s successful businesses have much more potential for long runways of growth and the Hut Group, a successful investment prior to its stock market listing for the Merian UK Mid Cap Fund, now illustrating the huge channel shift occurring in favour of the internet, as in its short stock market history since listing has delivered three revenue upgrades in a roughly six month period. Traditional businesses suffering from disruption may not have the financial strength to recalibrate their business models to compete with today’s disruptors, meaning there are more value traps than bargains amongst the low rated names listed on global stock markets. An absence of inflation, which has resulted in many businesses lacking any real pricing power, and oversupply in many sectors due to globalisation, has resulted in some businesses products or services becoming commoditised, where their only ability to compete against each other is through price. In today’s world of unprecedented technological change and innovation the application of formulas and investment methodologies that worked in the past has, and is likely to continue to lead to, a misunderstanding of what true value actually is and legendary value investor Sir John Templeton warned that whilst there could be huge risks when people say ‘it is different this time’, around 20% of the time they are right. One thing seems certain, that the purchase of lowly rated stocks which was once perceived as a defensive way of investing in the stock market, is no longer a low risk option for investors as a greater percentage of these companies are in terminal decline in the world of the 21st century than has occurred heretofore.
It is therefore no coincidence that many of the advocates of value are older investors, including perhaps Jeremy Grantham at GMO, who find it hard to believe that truly dominant companies will be able to achieve rapid, durable and highly profitable growth for many years to come. Many of the market leaders of today have demonstrated over the past five years or longer that high growth rates are achievable for longer time periods in a technology enabled world. Businesses with superior technology and corporate culture have obtained long term competitive advantages with faster growth rates achievable in asset light business models. This is not to argue that all highly rated companies are likely to be successful investments over the next decade, but that some will defy optically high short term valuations as their long term prospects are still not fully recognised by the market. A belief in mean reversion encourages investors to what has been described as ‘cutting the flowers and feeding the weeds’ and many investors in pursuit of diversification dilute returns, something that individuals do not do when listening to music or choosing restaurants. In an environment where certain winning businesses are likely to keep on delivering, running winners is likely to continue to be an important driver of returns for investors that are prepared to live with bouts of short term volatility. In a world where there is likely to be a continuation of a narrow list of successful rapidly growing companies with durable competitive advantages, taking profits in these at an early stage will clearly be a mistake as it significantly erodes the inherent asymmetry of equity returns where there is infinite upside but only 100% downside in any share. Loss aversion is an important psychological influence on investor thinking, and for many there is a fear of seeing profits evaporate when logic dictates there is an equal or even higher risk of selling out of a business far too early. The impact long term compounders can have on returns has been demonstrated by the Baillie Gifford Long Term Growth team in both their global and US portfolios and with few businesses capable of compounding high rates over longer time periods it is relatively difficult to find other stocks with these characteristics by selling out of those capable of delivering this at an early stage.
In conclusion on the growth versus value debate, it is necessary to recognise that the world today is different from that of 10 or 25 years ago and that successful growth orientated investment teams will continue to benefit from the unlimited upside in a limited number of strongly performing equities. Strategies focussed on finding these outliers have the potential to deliver the best returns. Value investing is likely to have periods of outperformance, but without a return to higher levels of economic growth or inflation their periods in the sun may be limited. Furthermore, many so called value businesses are in danger of long term structural decline, making them higher risk investment options today, whereas in the past they might only have been guilty of being an investment option that was extremely dull. This is especially true of those utilising value investing strategies either totally or highly reliant on low valuation metrics. Today where value actually is, is much harder to ascertain, certainly on a quantitative basis, making successful investment even more important about making superior judgements based on qualitative factors and future long term trends.
When Lawrence Summers identified the central importance of ‘secular stagnation’ for the global economy in his speech at the IMF in 2013, the Harvard Professor put his finger on the most important driver for financial markets for the remainder of that decade. For those believers in an era of secular stagnation the opportunities provided by high quality growth companies benefitting from a lower discount rate on future rapid earnings growth in a low growth world has provided a meaningful and extremely profitable investment opportunity. Summers interpretation of the term argued that excess savings relative to intended investment had driven the global equilibrium real rate of interest down and well below zero by the mid-2000s making it difficult for monetary policy to provide the typical stimulus after a recession. As a result inflation dropped below the 2% central bank targets in the US, Eurozone, UK, and Japan. It is these forces which explain many of the key trends in global markets over the past decade. Short term interest rates were able to remain “lower for longer” not because central banks wanted to promote a bubble in asset prices, but in response to the downward pressure on equilibrium real rates. This allowed a continuation of the bull market in bonds with nominal and real bond yields continuing to fall in advanced economies even through and below levels previously seen as the effective lower bound (zero). The demand for safe fixed income securities exceeded supply, resulting in a frenzied search for yield which spilled into corporate credit including non-investment grade and emerging market debt, leading to a significant tightening of credit spreads.
As a result equities have benefitted from the lower discount rate on future profits, especially for stocks able to grow earnings on a reliable and regular basis. Corporate profitability benefitted from low wage inflation, another possible symptom of secular stagnation. Even Robert Shiller of Yale University, who had earlier warned of equity bubbles, has more recently written as discussed that lower bond yields support the current high valuation of equities and there is no obvious equity bubble in the overall market at this moment. Equities which gained from technological and structural changes, in particular the US FAANGS (Facebook, Apple, Amazon, Google, and Netflix) have delivered outstanding returns as have many less well known but equally technology enabled disruptive business models, all of which have benefitted the most from declining discount rates. Secular stagnation has also arguably allowed a change in fiscal policy during the pandemic to be received calmly by bond markets who had become accustomed to large scale central bank QE and rising budget deficits. If in contrast global savings had been in short supply high government bond issuance would have raised interest rates, dimming the prospects for economic recovery. The direction of secular stagnation after the pandemic passes into history will remain crucial for asset prices.
Fuelled by vaccine optimism, highly accommodative central bank policies and record fiscal stimulus equity markets have now moved a long way to discounting the anticipated improvement in economic activity over the next 12-18 months. Valuations and investor sentiment are at cautionary levels and the pandemic catchphrase “stay safe” is now appropriate and equity investors need to be very alert to potential threats, hence this could well be ‘A Year of Living Dangerously’. Unfortunately, outside of equities there are few other asset classes which look attractive. Cash rates are zero, or in many countries negative, as are high quality government bonds and even investment grade debt has seen spreads contract to levels where absolute yields will not provide the required growth many investors require for their longer term financial planning. Property, in no small part due to the pandemic, has seen its attractiveness fall both in terms of retail and the likelihood of a contraction in future demand for office space. Equities have become the TINA (There Is No Alternative) asset class, but as more investors have come to recognise this, potential for a short, sharp setback on any bad news increases.
The critical near term economic variable is the virus, the effectiveness of the vaccine and the speed of roll out. There remains solid grounds for optimism here, although the South African strain changes a key part of the spike protein that the virus uses to enter cells, which potentially could, but only could, render the currently approved vaccines less effective. Tests are underway to examine this, with preliminary results from Pfizer appearing encouraging. At current levels equity markets are vulnerable should the timing for the vaccine fuelled economic recovery be delayed.
On the geopolitical front the rivalry between the US and China is likely to persist although in the initial stages of a Biden Presidency the Chinese are likely to adopt a cautious approach. Technology rivalry will remain a key battleground.
Looking a little further ahead to the second half of the year, assuming success with the roll out of vaccines there could be a sharper than expected upturn in global economic activity. This could see an increase in inflationary expectations and it is important that central banks continue to adopt an accommodative stance. Structural disinflationary forces remain but some cyclical inflationary forces are likely to gain ground and gather momentum over the next 12-18 months. There is no reason to yet believe that the three D’s of Debt, Demographics and Devices (technological innovation) will result in a long-term breakout of inflation above central bank targets. The best outcome for markets is that the same long-term forces that have dominated recent decades will re-emerge after the pandemic the ‘goldilocks world’. A continuation of the global savings glut is likely to keep equilibrium interest rates very low during the 2020s. As a result near zero bond yields should continue to support buoyant equity markets. This year, however, could see expansionary fiscal policy, especially in the United States, challenge in the short term the now more established or consensual view of low inflation and whilst this might be good for the world economy in the short term, it would not necessarily be good for asset prices. The factor most likely to puncture the long running bull market in global equities would be a rise in the long term discount rate applied to corporate earnings. Clearly, this battle will also determine over the short term the relative performance of growth versus value investment strategies. Value stocks typically outperform when growth becomes more plentiful and thus would be the primary beneficiary of the reflation trade if it persisted. Over the medium term, successful growth investors should benefit from the continuation of a winner takes most investment environment, but 2021 is a period when ‘living dangerously’ is the price to pay for the likelihood of continued long term investment success.
IRC Strategy Team 17.01.21