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Top Ten List

By: Stephen Colavito Jr.
Chief Market Strategist, Lakeview Capital Partners, LLC

December 2020

The Top Ten List


Once upon a time, late-night shows were less political and more about entertaining the masses.

One of my favorite segments on David Letterman was his top ten list.  Each night, host David Letterman would present a list of ten items, compiled by his writing staff, that circulated a common theme.  Some of my favorites were; Top Ten Things Never Before Said on the Sopranos and Top Ten Least Popular Christmas Carols. 

In honor of that segment, I decided to develop my top-ten list of things that could happen to the markets and the economy in 2021.  Like David Letterman, my list will go from least to first.  As a reader, I preface that this might not be as funny as Letterman's top ten, but hopefully, it might entertain you none-the-less.  So pull out your popcorn, and let's get started.

From the home office in Smyrna, GA – this month's top ten list; "Thing investors need to watch for in 2021!"

10: Risk beyond COVID-19

The most significant risks to both the economy and the asset-market could continue to be from health outcomes.  As COVID-19 continues to spike in Europe and the US, the prospect of a long period of new restrictions could weigh on the markets.  This pressure could continue through the second quarter of 2021.  Markets could have difficulty looking through economic weakness if there is any delay or problems with vaccines.

Several other issues could be amplified in that scenario.  There is a potential balance sheet crisis looming in the corporate sector, which has been helped by aggressive Fed policy response.  But, I continue to see more companies filing for bankruptcy and if a second wave of the virus causes another lock-down, look for those to accelerate.  In Europe, renewed growth weakness could also reopen fiscal capacity in the weaker (more socialized) countries. An extended period of economic weakness that runs well into 2021 could be the straw that breaks the ECB back and creates much pressure for their central bank.

Several critical political and policy uncertainties remain in limbo.  I will highlight the risks in both directions around the US fiscal policy later in this paper.  It appears that both parties have decided on a "stimulus down-payment." Still, the scope of additional stimulus and timing could affect the economy. Also, the prospect of further increases in geopolitical tensions with countries like China and Iran could extend well beyond President Biden's inauguration.

A more robust recovery could also bring its own risk.  For the credit markets, a growth impulse and further gains in equity markets over the next year could bring even higher valuations in focus in 2021.  I am not in the camp that sees the broad market valuations stretched (however, some companies are), given the current ultra-low real yield environment.  However, the market has "front-run" a lot of the vaccine news in stock prices, so if we see equities continue to climb, it leaves little cushion against any disappointments in earnings growth.  I hope that we see a "divided government" after the Georgia special elections because I believe it reduces the risk of higher growth outcomes under a "Democratic sweep" but does not remove them.  (Note:  I never like super-majorities of any party).

9: Get Hedged

 am a big fan of avoiding max-drawdown situations for clients' portfolios.  But, hedging and diversification constitute a significant challenge for many advisors and investors.  For the last 20-years, bonds have offered both positive returns and negative correlation to equity shocks.  Earlier this year, in March and April, those benefits were on display again.  However, in a zero-bound interest rate environment, the path of diversification becomes more complicated.  If equities were to fall again, bonds face a natural limit on nominal yields, even for long-duration bonds. 

So with the prospect of lower fixed income returns and diversification, advisors and investors have been searching for ways to mitigate the loss of diversification with traditional assets.  One option is to look at other assets to fulfill a similar purpose.  This author has liked gold for quite some time, and its correlation with equities has shifted from negative to positive.  I still like the asset. 

Another option is to replace equity risk itself.  For those who understand options trading, longer-dated calls provide one way of limiting downside exposure (at a cost). Substituting dividend swaps can help lower the duration of equity portfolios.  With high levels of volatility, put-selling may also benefit the portfolio as an equity replacement.  For those advisors or clients who don't understand options trading, mutual funds can do this type of investment for you.

The last option is looking for negative correlating asset classes that zig when equities zag.  You know that I have liked volatility as a hedge for those of you who have been long time readers.  This asset class played itself out well in the early part of the year. With higher levels of volatility expected, I continue to see this being a necessary diversifier in portfolios.

8: Look Beyond the US and into EM

Emerging markets (EM) have underperformed because of the Covid pandemic.  These countries have lost growth and have been impaired fiscally.  I would expect this to persist for several years, but these markets are remarkably resilient.  Despite a lot of new supply, EM investment grade credit spreads are almost back to pre-Covid levels.  Equities have moved through pre-Covid highs led by Asian (mostly Chinese) tech stocks.

Emerging markets have always been a high-volatility asset class, and I would expect that to continue.  However, across global markets, EM has value.  Areas like Asia, in particular China, could be in favor over the next year.  Although EM outperformance has been in short-lived bursts, I believe it has the potential to become something more sustained.  Having some exposure to the notion of such sustained outperformance may make sense for a small part of the portfolio.  Like the old Brylcreem commercial use to say, "A little dab'll do ya." Yes, I just dated myself.

7: Got Commodities?

The pandemic has brought on the phrases "New World Order" and "The Great Reset." When the World Economic Forum, the IMF, and Prime Ministers from several countries proclaim, "now is the time," – it's hard to dismiss them as conspiracy theories.  Ever since the advent of the pandemic in the early part of 2020, it has looked as though the existing order cannot hold.  That order, associated primarily with Paul Volcker, Margaret Thatcher, and Ronald Reagan, was built around independent central banks, global trade, and oversaw some two decades of impressive growth.  Then the order was "tweaked" by both Republican and Democratic lawmakers and central banks around the world.  As a result, the last two decades have been marked by repeated crises and deepening inequality and discontent.  Covid-19 appeared t administer the coup de grace. 

The new administration flip-flopped during the campaign on their stance on oil in the future.  Republicans made the argument during the campaign that progressives would try and push "A Green New Deal" at the cost of oil and natural gas producers.  Global climate change advocates have used this pandemic to try and implement carbon tax programs and clean energy standards with little thought to those adversely affected.  Without China and India's cooperation, even climate scientists admit there could be little improvement in global change (note: China continues to build new coal-burning plants so, good luck).  My feeling is that Biden is pragmatic enough to keep the extreme left at bay and wouldn't want to hurt US energy producers.  But, this is something to watch because "The Great Reset" is real.

So, as I focus on oil, the price decline (see chart below) created significant small-cap energy companies' problems.  The virus uncertainty and the potential for continued lock-down headlines all point to further price volatility in the commodity and even some potential near-term downside.  However, if these current prices are sustained, they could further impact supply, setting the stage for a potential rally in 2021.  If we see the economy start to accelerate in 2021, demand could likely face an under-investment in shale exploration and energy infrastructure.

Any real demand in Brent crude could send the liquid from the low 40's today up to the mid-'60s by the end of 2021.  This increase would be a partial retracement of the price of $76.41 in October 2018.

From a market perspective, if global economies start to recover and the pandemic starts to appear under control, a commodity bull market is likely as investors anticipate an acceleration in global growth.  Copper, crude, timber, and gas could all see an increase in pricing.

6: China is Gaining Momentum

China's economy has spent the last two-years negotiating a pre-Covid economic slowdown.  This slowdown led to a long cycle of underperformance in both Chinese equities and fixed income.  But, the country has made a remarkable recovery in a post-Covid world, which has elevated its gross domestic product (GDP) well past levels seen in the early part of the year. 

Say what you want on China's handling of the pandemic; what can't be argued is it has facilitated a sharper industrial supply response.  Its manufacturing sector is now back to full capacity, while industrial output in the United States and Europe is still significantly below end-2019 levels as firms grapple with ongoing disease outbreaks. Initially, China also benefited from strong demand in the United States and Europe for COVID-19 related products such as surgical masks and ventilators.

However, over the summer, demand shifted to electronics and communication equipment for households operating under lock-downs. Finally, in recent months, demand has risen for a broader range of industrial products that other countries cannot fulfill because of pandemic related disruptions. According to Chinese government statistics, monthly export growth rates have ranged from 15 to 40 percent for medical supplies, electronics, and home furnishings since late spring. That boom in exports helped drive industrial value-added growth to nearly 7 percent in September.

As I look into 2021, even with a little slowdown in the pace of credit growth and policy support, China could see 7.0% real and 9.0%+ nominal GDP.  In my opinion, this sets up for a period of substantial outperformance in markets that still have relative value.

When reviewing the chart below, if one is a "value" investor, it's pretty clear that emerging markets (EM) are trading below their historical price to book and earnings.  As we move past Covid and a more passive policy stance towards global trade by the Biden administration, I believe it makes sense for investors to look at these markets with a tilt towards China. 

5: Growth vs. Value – is there a choice?

If I asked most investors, "What has a higher return, growth or value stocks?" I would be willing to bet that most would choose growth stocks.  So, after doing some digging, I found a study by Bank of America interesting.  According to BOA, since 1926, value investing returned 1,344,600% versus growth investing, which returned 626,600%. It's not even close.

Yet, advisors' emphasis to investors on growth and value "tilting" to make their allocation pie charts look pretty, I think, misses the point.  Ultimately, I believe what matters to investors is not the relative returns over the past decade or past century.  What really matters are the relative returns over an investor's time horizon. 

As I have discussed in past papers, the market breadth this year has been very narrow.  The mega-cap technology stocks like Google, Amazon, Facebook, etc., have pulled both the Nasdaq and S&P indexes higher.  These are considered "growth" stocks, and as a result, many "value" managers have lagged the indexes.

Value managers have recently distanced themselves from the foundation of "value investing." These managers generally purchase stocks on the book value-to-price-ratio or market price multiple to book value.  The performance-related matrix managers use is fairly well documented, but this has led to an uncomfortable level of redefining what "value" is at this point.  My perspective is that price-to-sales, price-to-cash flow, and other factors (sectors or risk-free return) determine if a company is in the value or growth category. 

But more importantly, it's best not to try and chase these styles.  I have watched too many advisors in my 25+ years in this business, and investors chase performance based on style.  This investing can result in lower returns.  In one study, Vanguard found that buy-and-hold investment strategy outperformed chasing performance across all asset classes, which brings me to my final point, "do your homework."

Many value managers have moved away from their typical investing style (what is generally called "style drift) to achieve returns.  So even though the investor isn't chasing, the manager is.  This shift is a mistake and is one that needs to be identified by the advisor and investor.  Advisors need to view top holdings of clients 40-Act funds and discuss with managers if their valuation based evaluations have changed.  If so, change may be required.

4: It's About to Get Steeper

US government bond yields collapsed this year as the Covid inspired recession forced central banks to cut rates to zero and launch a slew of new QE programs.  As the vaccines are introduced to the public, and the economic recovery consolidates in 2021, I would expect to see more differentiation across the curve (curve steeper).  I expect policymakers to keep the front-end rate curve low, but higher expectations for growth and inflation could drive long-end rates higher.  This should be especially true in the US due to the Federal Reserve's new "Average Inflation Targeting." This policy is the Federal Reserves' way of scrapping its 2.0% target for one that floats, or better said, "we'll know when we get there."

If this plays out, it could lead to the 10-year getting back above one percent, and I believe trading in a range of 1.25-1.50%.  Should the markets experience a much sharper move than anticipated, this could be disruptive for equities and credit. Still, I believe with unstated but well-known Fed curve control, that is a low probability. 

A key question could be whether any central banks move rates into a (or more deeply into) negative territory outside of the US.  This position cannot be ruled out simply because a few central banks, including the Bank of England, continue to say the option could be considered.  But again, I view this probability as low.  Despite a deep recession in 2020, no central bank with negative rates cut more deeply (negative), and no central bank with positive rates entered into negative territory.  So, unless we go back to a global lock-down, I view this as low-risk.

3: Risks

The prospect of an effective vaccine and Republicans holding the Senate (more on that in a second) underpins my baseline forecast and is bullish for the medium-term market outlook.

However, I think two real risks remain.  The first is the possibility of additional and more in-depth lock-downs.  Some studies I have read have estimated that 20% of all small businesses have either closed or are on the brink of closing (that's a staggering number, which politicians don't seem to understand).  These lock-downs may temper optimism about the cyclical recovery, at least until a safe and effective vaccine has been confirmed.  European governments have so far introduced milder restrictions on public activity compared with earlier this year.

I would downgrade my US economic and market expectations on the back of new Covid restrictions because it would likely restrain the prospect of an economic rebound.

2: The Election is Not Over Until January.

As most of you know, I am fiercely independent in my political thinking.  I believe absolute power corrupts absolutely.  So I am against any political party having a super-majority (White House, Senate, and House).  Beyond my personal political feelings, I believe the run-offs here in Georgia could also be a risk to investors.  I realize this is a touchy subject for some, so please understand these opinions are mine and not of Lakeview Capital Partners.

To make this simple and one that most constituents in both parties agree with - here is why the elections here in Georgia have meaning.

Should the Republicans hold both seats, I believe it gives President Biden a little cover from his left flank and could allow for more moderate policies for his first two years.  Moderate tax-increases could be absorbed by an economy that is trying to recover in a post-Covid world.  Secondly, any healthcare policy would be in the form of reinstituting and correcting Obamacare versus the more liberal wing trying to press the administration to a single-payer system (Medicare for all).

However, if Democrats win both Senate seats, I believe the markets' initial reaction could be adverse.  The markets will worry that the more progressive side of the party could push for much higher taxes, a Green New Deal, a higher federal minimum wage (which should be at the state level), and a single-payer healthcare system.  Individually they could be digested, but collectively these policies could create a head-wind for job recovery and the economy.

Maybe it's wishful thinking, but I would like to see a balance of power and the parties start to compromise.  There is too much animosity in both parties, and it's time they start working for us and not the other way around.

1: The Fed Led the Markets Higher This Year; Vaccines Could Lead In 2021.  Have A Long-term Path.

Despite an impressive rebound through the middle of this year, economic activity remains depressed in the US and Europe.  Unlike most business cycles, this time, the economy is being held back by a public health crisis.  As a result, the economic and market outlook largely depends on the prospects of controlling the virus.  Depending on the distribution of public vaccination and herd immunity – along with the help of friendly monetary and fiscal policy – it is possible that a large portion of lost output could be restored by this time next year.

If I were to simplify assumptions, "herd immunity" requires immunity (through infection or vaccination) equal to 1-1/R0, where R0 is the disease's primary reproduction number. That's the simple version.  In reality, the herd immunity threshold is not a fixed number but a function of effective transmission rates determined by the degree of social distancing, temperatures, populations, and other factors.  But let's keep this simple and assume that R0 was 2.5 (as suggested by studies by the CDC), reaching herd immunity would conservatively require immunity in 60% of the population. However, that threshold may be lower because of population heterogeneity. 

If hypothetically, 10% of the population has gained immunity through infection (count me as one of those people) and will not initially get vaccinated, a vaccination campaign would need to inoculate 55% of the population with a 90% effective rate (as indicated by the early Pfizer data) to get to the 60% mark.  With an acceleration of various vaccines' distribution, this could be potentially achieved by late Q2 or early Q3.  This would be the "delta" or inflection point where the economy should show real signs of our pre-Covid days.

So with that in mind, investors should position their portfolios for a broader and deeper global economic expansion in 2021, which could favor riskier assets in general, but the most growth-sensitive assets in particular, including commodities, cyclical equity sectors, and emerging markets.  The timing of this expansion is dependent on vaccine distribution and fiscal stimulus so that volatility could remain an aspect of these markets. Still, I anticipate that risk assets will have long-term benefits.  On the flip-side of that trade, safe-haven assets such as the US Dollar and US Treasuries should continue to underperform, especially if inflation expectations pick up.

Investors need to meet with their advisors to plot a plan for the coming year.  However, a different plan that is broader than the prototypical stocks, bond & cash allocation is warranted.  Advisors and investors should look at alternative asset classes that would benefit from a much broader economic recovery.  Unlike 2020 when market breadth was narrow to a handful of post-Covid technology names, I believe real diversification could provide alpha to investors' portfolios.

Until next year, I wish you a very safe and happy holiday season.  Be well.