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Five key takeaways for 2021
As the pandemic quietly passes the one year mark, let’s take some time to reflect, analyse and look ahead. What can we expect after this rocky start to the new decade?
Like we did last year with the US-China trade war, let’s start by taking a closer look at the investment implications of the global COVID crisis. The pandemic has led to formidable worldwide challenges, and put a lot of strain on our globalised and interconnected way of working. Still, even the darkest clouds have silver linings. A bird’s eye view of 2020 can give us some valuable investment takeaways: This year’s substantial central-bank balance sheet expansions have muddled the distinction between monetary and fiscal policies. The rush for a vaccine has opened the doors to a novel class of drugs (mRNA), heralding great promise for, amongst others, cancer treatment. In addition, the pandemic has highlighted China, Taiwan and South Korea’s ability to swiftly deal with, and recover from extreme events.
Most importantly though, we have witnessed a noticeable acceleration of pre-existing trends, as well as the emergence of new trends, such as telehealth. Indeed, the pandemic and the resulting global lock-down have served as powerful catalysts for certain (sub-)sectors. For example, it has led to a global revision of the resilience of our health care systems, after the pandemic exposed several key shortcomings in this sector (e.g. the paucity of diagnostic testing capacity and speed or lack of ICU bed capacity). Companies with high labour process density will have to increasingly rely on automation as their operations have been severely impacted during the pandemic. In addition, this year’s many conference calls, the working-from-home thematic, and our ever-growing reliance on cloud applications have kick-started a veritable technological revolution, both on a private, government and corporate level.
These have been some of this year’s main structural trends, and clearly illustrate why (big-cap) tech companies have dramatically outperformed the S&P500. The acceleration of these themes has drawn a clear dividing line between disruptive companies/sectors on the one hand, and stagnating, disrupted firms/industries on the other.
As mentioned, the pandemic has been a boon for tech stocks. As the NASDAQ reached hitherto unseen heights, people have been quick to draw parallels to the Dot-com bubble. Still, it is important to keep in mind that, while we are noticing a peak-polarising trend of growth over value, there is actual substance to it this time around: Today, the momentum of the IT sector’s free cash flow generation has been roughly in line with the increasing market capitalisation representation in the index.
Like the global financial crisis (GFC) in ’08-09, the COVID crisis’ economic and societal impact has had unique and wide-reaching implications. However, here too, there has been a clear difference between the two. During the GFC, individuals had a clear sense of trauma, as people lost their jobs and homes. However, today, people and governments exhibit a greater desire for change, and a greater awareness of societal challenges. This has, in part, contributed to such mega-projects like the EU Green Deal or China’s ambitious climate change goals, for example.
Markets finally got to breathe a sigh of relief in November. Moderna and Pfizer’s vaccine results brought some much-needed Christmas cheer to this otherwise gloomy year. Biden’s victory, a split congress (depending on the Georgia election run-off), and the resulting expected political stability also received the markets’ stamp of approval. Even though it has been a rough year for cyclical and small cap stocks, the prospects of mass inoculation completely re-shuffled the deck. It let these struggling segments catch up before the start of 2021. This has led to a most remarkable end of year, with a uniquely large rotation and a closing of the return gap between the worst and best sectors in Europe for the year.
Performance of MSCI Europe by GICS1 sector YtD
Source: DPAM, Bloomberg, November 2020
Where do we go from here? Does the end of the lockdown and the re-opening of the economy foretell the end of growth strategies in 2021? We don’t think so. For investors with the right, long-term time horizon, this is just a short-lived switch and an opportunity to add to long-term convictions. When we take into account the development of structural trends, we expect to see a shift from peak polarisation to eventual normalisation, but do no discount an enduring regime shift (i.e. a great rotation).
In this context, value investing remains as relevant as ever. However, it is critical to correctly define the meaning of ‘value’ investing, and look at the right metrics. Value investing does not simply refer to ‘investing in value stocks’. Simply relying on static multiples in companies, such as price-to-book ratios, will offer twisted results. One should not focus solely on such multiples, but, instead, make sure to understand how a company makes money. Increasingly, this is done by investing in intangible assets, be it software development, digital capabilities, R&D, … . These are inherently more scalable (not only through economies of scale but also through network effects) than tangible assets. Whenever a company invests, it is always important to understand whether that means higher cash flow generation going forward, with a return on investment capital that is higher than the cost of capital. Shorter duration assets, which are often more ‘tangible’ heavy, have cash flow profiles that are closer to the present, but often fail to realise a cash flow growth with a return on capital that is above their cost of capital. This destroys shareholder value. Instead, we would encourage investors to invest in compounding companies (i.e. firms that increase their free cash flow over time, by investing in, among others, intangibles), be they large or small caps.
Finally, let’s consider how inflation could impact equity markets in the coming years. Panicked reports have been emphasising the likelihood of high inflation in the near future, and the potentially dramatic impact on equity due to its longer duration sensitivity. To us, the outlook is more benign. Even though we might well go up to 2-3% inflation based on the substantial jump in money supply , we have no reason to believe that equity will suffer significantly in return. Not only do equities offer an inflation hedge (due to the comfortable yield gap with government bonds), but looking at the graph below, equity multiples should not suffer dramatically, as long as inflation remains contained.
US average trailing PE, 1972 – present
Source: Refinitiv, Credit Suisse research
In addition, there are also several disinflationary elements at play (e.g. increasing tech adoption, demographic pyramid, output gap, etc), which should further hinder an ‘out-of-control’ inflationary scenario in the near future (see CIO view).
In conclusion, we are generally optimistic, but only cautiously so, certainly when plotted against the sell-side consensus. Markets have gone through a massive shake-up in a year that has been characterised by peak polarisation. It is also important to keep in mind that eventual normalisation (i.e. reopening of the economy) has already been anticipated by markets, as shown by the stunning market performance since the announcement of the vaccine news. At some point in 2021, reality could set in with potential risks to high expectations, worries about large debt levels, peak liquidity… Make sure to be selective in buying so-called COVID losers, and focus on long-term structural trends to make the best of any future headwinds.