4th Quarter, 2020
Investors need greater clarity of the strength and direction of the post COVID-19 world.
THE MARKETS
During the 4th Quarter, markets meandered at the outset and then began to rally in response to better than expected reported earnings, bullish news relating to vaccine discovery and approvals and a growing conviction that election results would not herald far-reaching policy changes but rather a more balanced agenda for change. Concerns about the severity and longevity of the pandemic were nowhere near the level of heightened anxiety that roiled the markets late in the first quarter.
The quick and coordinated global fiscal and monetary stimulus provided an unprecedented G20 ring-fence that calmed pandemic driven market turmoil. The result was the underpinning of a broad “risk on” rise in most markets that continued through the year. Financial markets thus far have weathered the perfect storm of COVID-19, the OPEC rupture and the economic disruption that upended much of the service economy. The markets also appear to have adapted reasonably well to the rapid supply chain and social order disruptions that have unfolded in the last three hundred days. Looking ahead, investors need greater clarity of the strength and direction of the post COVID-19 world as we focus on the ways and means of amortizing the costs of healing and stabilization.
The elixir of market exuberance is a cheap and plentiful money supply. However, a price of this elixir has been structural deviation in the historic relationship between real interest rates and stock and bond valuations. So far, investor liquidity has migrated with noticeable velocity to equities, reducing the appetite for fixed income assets, which the markets sense offer less than fair value in the present “risk on” scenario.
The clear and present danger of the prevailing risk appetite begs the question of whether current equity returns are borrowing too much from future growth expectations. The Federal Reserve’s stated interest rate policy of “lower for longer” appears to be the linchpin in this relationship.
At present, markets appear to have effectively identified sectors that have sustainability of growth along with pricing power and hence the ability to grow earnings and real cash flows in the current muddled economic environment.
The future challenge to financial market valuations will arise from central banks setting forth new policies to sustain employment and growth and reestablishing a policy of real interest rates. Will this then lead to a reset of asset valuations?
THE ECONOMY
The global pandemic has wrought a spate of economic and social disruptions in a compression of time that defies comparison. What is now abundantly clear is that there will be no “status quo antebellum.” The development of new social and economic norms is in process, but not yet fully in focus. Some changes will come sooner, others later.
Demographics will figure prominently, as will such issues as income inequality, medical care, education and the shared roles of government and business in a capitalist economic system. As such, we may see changes in the way future economic cycles play out. For now, our traditional methods of economic measurement must continue in use until conditions dictate modification or change.
The most recent data suggests a 2021 unemployment level at 8 to 10%, which then raises the specter that continuous government stimulus will be required in the form of direct individual aid. A continuation of “lockdowns” and travel restrictions will likely raise the level of unemployment particularly in service sectors. The continuation of small business closures may be a precursor to new layer of structural unemployment. We must also recognize that there are significant numbers of college graduates from the class of 2020 who have never been employed or even counted in the workforce. This is likely to be repeated in the spring of 2021. It is important to track these trends as much of the fallout will affect lower paid service workers, raising the stakes in the income inequality conundrum and ultimately, public policy decisions.
The focus on employment has direct bearing on forecasts of consumer spending and thus expectations for GDP growth in 2021. Employment and wage factors then become a major component of the Fed’s “lower for longer” policy which telegraphs that monetary policy will initially lag in a response to inflation. In the other areas of government spending and corporate capex, deficits will rise and capex will likely be determined on an immediate need basis.
Reliable scientific thinking suggests the Global COVID-19 pandemic will run its course in 1,000 to 1,500 days, which, roughly translated, is three to five years of disruption and economic drag. We are now about one third through the shorter estimate of the disruptive cycle. Science appears to have the upper hand in the vaccine antidote; however, there is a risk that ineffective and disparate public policy will hinder medical success. The unknowns of mutation and viral transmission will remain in any case.
The foregoing suggests continued caution in relying on reported economic data to forecast aggregate growth. Until we are more or less certain about the course of pandemic recovery the best approach is to closely follow sector activity for sustainability of growth and adaptation to changing circumstances. In the interim, we should be prepared to react to scenarios of two steps forward and one step back.
INVESTMENT STRATEGY
Year-end domestic stock indices hovered around record historical highs with the S&P 500, Dow Jones Industrials, and the Russell 2000 up 16.3%, 7.3%, and 18.4% respectively, while US Treasury yields near record lows demonstrate the force of the Fed’s “lower for longer” interest rate policy.
The message for some time has been that there is no alternative to owning stocks. The markets have been pushed higher by negative real returns on cash, rich valuations of corporate bonds, record margin debt, and a feverish demand for IPOs that in many cases are burning cash but growing rapidly in a disruptive economy. The present state of the markets is unique in that events are not being driven by financial logic but by a public policy quest to end the global health pandemic and secure humanitarian and economic buoyancy for the future. While these goals are laudable, the ferocity with which they were launched some nine months ago has created excesses due to misallocation of resources from genuine recovery efforts to unneeded increases in leverage and financial engineering that have short-changed Main Street.
The stock market now has the appearances of a Nantucket Sleigh Ride - think of a whaling boat being taken for a wild ride by a massive sperm whale - compounding the difficulty of balancing return and risk. Our strategy continues to emphasize long term growth with a focus on companies that build value through solid stewardship of capital, providing shareholder reward through growing dividends as well as astute reinvestment for the future of the business. In the early stages of COVID-19 we reviewed our equity holdings on the basis of financial stability, sustainability of the business model and the ability of management to navigate the challenges of a post pandemic order. We also conducted a sector review to identify how new norms were likely to affect a reordering of industry growth and profitability and how we should rebalance sector weightings. We have also discussed the impact of a weakened dollar vis a vis export potential for US companies and opportunities for investment in high quality non US based global companies. As markets move higher, we continue to rebalance our holdings, mindful of the risk inherent in oversized positions. We believe your portfolios are well positioned and will withstand short term market volatility, providing opportunity for reward over the longer term.
THE ORIGIN OF A SYSTEMIC CLASH AND THE RISKS THAT FOLLOW: AMERICAN CAPITALISM vs. THE CHINESE COMMUNIST PARTY (CCP)
Prior to the Nixon- Kissinger diplomacy that brokered the establishment of diplomatic recognition of the People’s Republic of China, the American position was rooted in firm support of the Nationalist Chinese government in Taiwan, a beacon of emerging market capitalism. Diplomatic recognition of the People’s Republic of China furthered the U.S. goal of separating the major communist alliance of the CCP and the Soviet Union, but it also opened the Tiger’s door to a seat at the global leadership table and the tantalizing delights of capitalism. The US had achieved a major short-term objective of cleaving the communist world, while the CCP saw this as a long-term windfall to help reclaim their historic dominance in Asia. Western democracies tend to focus on a time table of a four or five year electoral cycle whereas the CCP has a time line of 25 to 50 years to achieve its goals. Therein lies the origin of the systemic clash between western capitalism and Chinese collectivism.
The CCP has never abandoned its Maoist precepts, but has availed itself of the fruits of capitalism that have served as an accelerant for rapid economic growth. This in turn has created a wealthy class of princelings and growth of an expanding middle class. The CCP accomplished these things while fostering their strategic goal of rolling up Hong Kong, Macau and the South China Sea, with Taiwan very much in sight.
At the outset of the opening of China in the 1970’s, Wall Street types were salivating over the success of PepsiCo in the Soviet Union and openly postulating what six hundred million Chinese would do for Coca Cola if they drank a bottle every month! Herein lies the major American risk in the clash of cultures. In the rush to gain access and edge out other western competitors they ignore the realities of systemic differences and succumb to the Chinese carrot and stick. Investments are made with little or no legal recourse. Government policy can change quickly by decree. Direct foreign investment in China involves conflicting systemic risks where honey can turn to vinegar before the next sunrise.
Recent political moves within China demonstrate the reinvigoration of absolute Maoist control and the expansion of industrial and scientific espionage. They show little regard for vast segments of the population that do not belong to the party. American companies face a major challenge in balancing the systemic risks of investment in a non-capitalist culture with the rewards that a growing consumer society presents. As a result, managements must be ever more vigilant as they exercise their fiduciary duty to employees and shareholders.
As always, your questions and comments are welcome.
Our best wishes for a healthy and prosperous 2021.