2020 was an extraordinary year on many fronts. While the economic woes of social and economic lockdown continued to afflict the physical and mental health, as well as the economic wealth, of so many, investment markets quickly regained poise and in some cases tested new highs. Although UK stocks struggled (more on that later), broader returns from risk assets were robust, and representative of a ‘normal’ year. Safe assets (government bonds) were rewarding too. Crisis? What crisis?
Governmental policy in response to the health pandemic, with a small number of very notable exceptions, appeared hesitant and behind the (admittedly moving) curve. Policy to address the economic impacts, however, from both governments and central banks, has been impressively decisive by comparison, giving investors a combination of assurance and ‘no other option’ sufficient to support financial assets.
This simple analysis has a degree of cheapness attached – sectors particularly affected by social-distancing measures struggled (and continue to struggle), while business models built around connectivity and delivery came into their own. Vaccine optimism redressed this balance at the margins towards the end of the year.
So what of the outlook for 2021 and beyond? Will Covid-19’s economic scars come to bear on investment returns? Can government bonds diversify portfolios (or indeed produce a worthwhile return) from current yields? What of the prospects for equities? Will the UK market recover lost ground? Will the stimulus finally reignite inflation? Of course, the answers given now can’t be definitive, but we need to position portfolios to give the best chances of long-term success in the face of the probabilities as we see them. This is how the Newton charities team sees the outlook.
First, it pays to recognise that we have no more insight than most on how the pandemic will pan out over the coming months, or how effective vaccines will be – either in terms of duration of protection or against new variants of the virus. We do know that there are many more people in the world than there will be vaccine shots this year, and that a full global public health recovery is some way off still. We can, however, focus on other observable trends and themes, and position ourselves accordingly.
While significant parts of the economy have been, and remain, mothballed, much of it continues and parts have had a pandemic turbo-charge. Pre-existing trends towards digitalisation have been accelerated, and appropriately exposed stocks have prospered. That trend is unlikely to be reversed, but the valuations that we are currently asked to pay for the exposure may become exposed. Disappointments on execution, or a higher-return environment in other assets, may lead investors to reappraise valuations in this area. We remain committed, but have taken care to take profits, invest in companies whose valuations we can understand, and watch position sizing and portfolio risk.
Elsewhere in equities, we have more recently seen some early optimism return in areas dependent directly or indirectly on social interaction and a functioning economy, and therefore a broadening of the market advance across cyclical sectors. While economic hardship is far too widespread, there is pent-up demand, and consumers and businesses in aggregate have been saving cash during lockdown phases. Some structural unemployment may result, but equally income in the pockets or bank accounts of those most affected is likely to be spent quickly in the real economy. As a result, recovery in the real economy should be swift when society reopens. As a generalisation, we believe valuations in cyclically exposed stocks and sectors offer scope for gains.
UK equities – better times ahead?
The UK, perhaps with modest Brexit impacts aside, has fared no worse than other European economies. However, the UK stock market has a peculiar and biased make-up, which has exposed it disproportionately to the Covid-19 downturn. Portfolios that have a UK bias, which is often the case for investors who favour income, have underperformed, although vaccine optimism encouraged outperformance in the final quarter of 2020. The income advantage of the UK market is diminished by pandemic effects, but not extinguished. The presumption in favour of a fuller global opportunity set in stocks (without a UK bias) has increased and is increasing, particularly for those happy to rely on total (capital) return, but the timing of moves in that direction requires care. A move on the back of the divergent performance of last year (and divergent valuations) requires careful thought, not least on understanding income impacts. Additionally, conditions and valuations may support relative recovery in the fortunes this year of UK equities, and good global companies with attractive valuations could be additive to 2021 performance.
The repression of interest rates and demand from price-insensitive buyers (central banks) has kept government bond yields ultra-low, leading some to the conclusion that these assets have no place in portfolios. We would agree that their diversification benefits are reduced, and return prospects are limited. Bonds historically have helped reduce risk in portfolios. Portfolios without exposure to safe government bonds are (we would argue) riskier, but we recognise that even if your portfolio owns government bonds, at such low yields, and with the likely correlation to equities, it is ‘riskier’ than when bond yields were more ‘normal’. Our government bond exposures are significantly lower than they have been, but we are not ready to abandon them altogether. Risk is elevated across all asset classes, and in a real ‘risk-off’ environment investors will be glad for their protection and the liquidity they provide.
The outlook for commercial property looks to us to be challenged. Retail property remains under structural pressure (elevated by pandemic effects), office real estate is uncertain while working patterns are reappraised, and valuations in distribution sheds appear generally to reflect demand. Investors need to be able to bear the illiquidity inherent in the asset class. We will hold property, but for specific client reasons.
Rising inflation risk
The final, and perhaps most important, piece of the jigsaw, especially for long-term charities, is inflation. Many predicted resurgent inflation as liquidity was pumped into the financial system after the 2007-8 global financial crisis, but we believed this was an unlikely outcome, given the deep structural deflationary counterforces (the deflationary impact of high debt, ageing populations, and the disruptive march of technology) and policies of fiscal austerity. The structural deflationary counterweights persist, and should not be underestimated, but expansionary fiscal policy has replaced austerity, and so the risk of inflation has certainly risen, and portfolio construction needs to be cognisant of that. Inflation is the enemy of fixed-coupon bonds, especially when yields are so low, and we are accordingly light in those. Higher interest rates (and bond yields) may upset highly rated growth equities more than those in consumer-facing areas with pricing power (and consequent ability to protect margins), so careful balance in equity selections around valuations and pricing power is key.
Risks around environmental (climate change), social and governance (ESG) factors remain key in the assessment of investment opportunity. Deep integration of ESG research is as necessary as ever in fully understanding the true extent of the financial risk in a company, and highlights opportunities for improvement too. Over and above ethical standards and values, the ability to assess and manage ESG risks and opportunities in portfolios will be ever more important in the achievement of good investment outcomes.
Valuation is key
Economic activity and growth should pick up from current, Covid-19-affected levels. Market valuations are ahead of that already, funded and encouraged partly by central-bank and government largesse, and so growth is required to justify current asset valuations. As much as we look for diversifiers and risk mitigators, we find risk (if only valuation risk) elevated in most areas. Appropriate positioning to us appears therefore to be: constructive on well-chosen equities, with attention paid to balance and valuation; light on government bonds (but we are not ready to abandon them from portfolios or benchmarks); and taking particular care in property and other alternatives, where illiquidity features need full consideration.
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This is a financial promotion. These opinions should not be construed as investment or any other advice and are subject to change. This material is for information purposes only. Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell investments in those securities, countries or sectors. Please note that portfolio holdings and positioning are subject to change without notice. Issued in the UK by Newton Investment Management Limited, The Bank of New York Mellon Centre, 160 Queen Victoria Street, London, EC4V 4LA. Registered in England No. 01371973. Newton Investment Management is authorised and regulated by the Financial Conduct Authority, 12 Endeavour Square, London, E20 1JN and is a subsidiary of The Bank of New York Mellon Corporation.