Multi-Asset

Demers: What 2020 taught us about 2021

With 2020 in the rearview, Fred Demers offers a retrospective on the year gone by – including an analysis of the best (or worst) strategies, sectors, and trendlines for institutional investors.
January 2021

Fred Demers

Director, Multi-Asset Solutions

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With a good perspective on history, we can have a better understanding of the past and present, and thus a clear vision of the future.

Carlos Slim

Validation of long-term thinking

History will undoubtedly remember 2020 as a year of crisis and upheaval. From the devastating human cost to the mounting economic toll, it was a period of drastic change that many investors are eager to leave behind, especially as COVID-19 vaccines reach wider distribution. Unprecedented as it was, we think there’s value in looking back to see which of our calls were right, and whether changes are required to navigate the year ahead.

For instance, 2020 delivered a strong rebuke to short-termism. Investments that were aligned with long-term trends, such as the shift to e-commerce from brick-and-mortar retail, or the rise of healthcare services for aging populations, benefitted greatly from the COVID-19 disruptions. Notably, the pandemic accelerated these secular drivers, creating an uneven market rally that was characterized by wide differences in sector performance. While indexes generally finished the year on a positive note, active managers required a well anchored thesis to find outperformance on the equity side of the portfolio.

Enduring strength of U.S. equities

Perhaps our most well anchored thesis of the last decade was a geographical bias to U.S. equities. This tilt proved fruitful in 2020 as American companies continued their growth leadership over Canada, Europe and Emerging Markets. Now, as the vaccines promise an end to the pandemic era, the focus may return to valuations, with some analysts claiming that price-to-earnings ratios are “too high.” We see no cause for immediate alarm though. Our long-term forecasts show that relative to key variables – such as growth, interest rates, inflation and inflation expectations – the broad U.S. equity market is priced within reason. 

We also benefitted from foreign currency exposure to the US dollar, which soared relative to the loonie when investors panicked last year and flocked to the familiar safe havens. There were notable gains in risk-off assets in February and March. However, after the volatility quelled, the Canadian dollar joined other currencies in regaining some ground – a trend that could continue as the economic situation normalizes and commodity prices rebound.

Looking ahead, we continue to believe there is value in a U.S. bias, though not perhaps as much as previously expected. Average GDP growth in the past 10 years has been approximately 2.5% per year, whereas it was closer to 3.5% in the decade preceding the Great Financial Crisis. This decline has been worrying. Also, it’s important to note that the country’s aging population contributes to slower growth, and forces companies to compete for market share rather than reaping the rewards of organic expansion. With the economic pie growing less quickly, we expect lower alpha from this trade going forward.

At the same time, we have been very impressed with how EM countries handled their COVID-19 response plans. China, in particular, was so successful in quickly controlling the virus that it will likely have less scarring in the economy and even saw its economy grow 2.3% in 2020. This dovetails with our overweight exposure to EM, which we returned to last year as shipping lanes reopened and trade began to pick up in Southeast Asia. Meanwhile, we have yet to see such positive developments in Europe, which continues to face significant headwinds related to weakened demand, Brexit, and a new rampant strain of the virus.

“New economy” leadership will continue

Another trend that accelerated during the crisis was the transition to “new economy” sectors, which encompass not only technology issuances but also companies that stand to benefit from structural changes in how we work, shop and live. The obvious examples are Amazon, Shopify and Zoom – businesses that profited immensely from the new work-from-home dynamic. While their gains were larger than expected, the world was already moving toward e-commerce and away from brick-and-mortar retail – the lockdowns merely sped up the process.   

On the other side, we’re conscious that some “old economy” sectors may not recover from current levels. We typically buy beaten sectors in the knowledge that they will rebound as the cycle turns, but repeated lockdowns have taken a toll on the economy. There is permanent scarring which in all likelihood can’t be undone. For example, as much as we believe the travel and tourism sector will enter a recovery phase this year, some players have been put out of business already. So, while overall economic activity will probably revert to historic norms, we believe the fundamental split between old and new economic sectors has been irreversibly altered.  

Coming back to the question of price, we have been more cautious on valuations since March. Despite the short time frame, the retracement from the second quarter brought us to a mid-cycle recovery much more quickly than anticipated. Active managers now have to be cautious about what to overweight. In fact, my team is keeping a close eye on earnings resilience to ensure we’re not overpaying for assets, because full normalization is still months away, and many sectors could need government support to help bridge their way to the post-COVID world.  

Expect more central bank intervention

The other big trend that influences asset prices is central bank intervention, a theme we have written about at length. Monetary authorities acted quite decisively to ensure liquidity at the height of the crisis, slashing rates to near zero, and pouring money into financial assets. Now with fiscal deficits set to rise this year, not only in Canada, but the U.S., Europe and Australia too, central banks will need to keep purchasing assets and aggressively monetize government debt.

Consider this: when we think of policies that support asset prices, the focus typically goes to actions undertaken by the Bank of Canada (Boc) and the U.S. Federal Reserve (the Fed). However, as governments look to deploy stimulus packages and bring unemployment rates back to pre-COVID levels, they will have to act on the fiscal policy side. The fact is public sector spending will be extraordinarily high, and could have a greater influence on asset prices than at any point in the past decade. As such, we expect the monetary and fiscal authorities to work collaboratively on a “synchronized policy” effort.  

Twenty years ago, markets would have reacted negatively to such exorbitant spending. Today, however, the pandemic is considered similar to wartime, where the government has legitimate grounds to use expansionary fiscal policy as needed. Some investors may disagree with this perspective, but again, central banks now own huge proportions of government debt. They can mitigate anxiety about structural deficits as they see fit, whether that’s the ECB in Europe, the Fed in the U.S., or the BoC in Canada. It is a Faustian bargain, one which will take decades to unravel, and investors should not fight it because the printing press carries unlimited firepower.  

Treading carefully in fixed income

Interestingly, equities were not the only reason that 60/40 portfolios performed well in 2020 –there was also growth on the fixed income side. This was particularly true in Canada, where monetary policy makers had accumulated more dry powder than in other developed markets. In Europe and Japan, for example, government bonds had fallen below the zero lower bound even before pandemic began, meaning there was very little room to cut interest rates once a crisis struck. By contrast, the BoC had more space to maneuver. As interest rates collapsed across the curve, there was significant capital appreciation. Moreover, fixed income assets did their job when markets crashed in February and March, providing diversification to equities and acting as buffer against portfolio volatility.

Conclusion

Given that past events are weak indicators of future performance, the world is unlikely to experience the same crisis twice in a row. The Great Financial Crisis bears no resemblance to the Dot Com Bubble, in the same way that the coronavirus pandemic has nothing to do with subprime mortgages or collateralized debt obligations. But while history does not repeat, it does rhyme. So, rather than seeking to forget 2020, we heed the words of the famous philosopher, George Santayana, who once said that, “Those who cannot remember the past are condemned to repeat it.”

 

For more insights, analysis and investment ideas, contact your BMO Global Asset Management Representative to discuss tailored solutions that meet your investment needs.

 

Disclosures

Not intended for distribution outside of Canada.

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This communication is intended for informational purposes only and is not, and should not be construed as, investment, legal or tax advice to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Past performance does not guarantee future results.

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp., BMO Asset Management Limited and BMO’s specialized investment management firms. 

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Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

 

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