2021: REVENGE OF THE CONTRARIAN

By Nick Watts, Non-Executive Director, Forster Chase

As we enter a new year, in investment offices and boardrooms around the world there will be the usual discussions as to how 2020 worked out against expectations and what 2021 will hold for economies and the capital markets. Of course, it will be a bit different this year as most of these discussions will be happening virtually!

Investment is a continuous activity so why this focus on a particular 12 month period that has just passed or the next upcoming one? The truth is that investors are wired to look at things that way for various reasons. We have a need to measure, review and seek renewal. If things have not gone well; why and what should we do about it? If we have prospered we need to guard against complacency. The future is unpredictable but variability in performance is a certainty!

So this year, like any other, market commentators will be trying to predict the key drivers that affect markets and currencies namely the direction of interest rates, the outlook for inflation and corporate profits. They will then attempt to apply some valuation criteria to arrive at their conclusion as to where markets will be by the end of the year. If anyone reading this article is expecting it to contain forecasts for markets, they might as well stop reading now as they are going to be disappointed! I stopped being paid to do that kind of thing a long time ago!

After a long (arguably too long) career in investment there are a couple of phrases that people use that lead me to automatically shudder. I have heard them too often and they are never true. The first of these is that an opportunity or a situation is “unique “. I suspect that this word will be all too freely bandied about this year to describe the situation we find ourselves in.

The second phrase that makes me very nervous is when someone says “it will be different this time because …”.This comment is usually made to justify valuations that are by any historical standards ,exorbitant. It never turns out to be a sustainable statement in the long run

So as we look at the potential for markets in 2021, I would strongly recommend retaining scepticism and be cynical when you hear these two phrases. In investment things can be very differentiated or unusual but never unique and valuation does matter in the long run.

One of the things that strikes me as I read various commentators outlooks for 2021 is how positive the consensus is and how sharply that contrasts with the way most of us are feeling right now enduring for months the equivalent of house arrest and watching the economy crater in a way that has not happened for centuries (literally).

Against this bleak backdrop, it must seem incomprehensible to people who live outside the markets that the valuation of many markets would lead many to believe that we are in bubble territory. Whether it is the tech boom, bitcoin, the valuation of Wall Street or that we are in negative real yield territory in the bond markets, one cannot escape the conclusion that there is very little room for disappointment in current pricing. How can this be possible when there is so much bad news out there and worse to come in the immediate future? Of course, if I knew the compete answer to this question I would be sitting on a beach somewhere (well actually in today’s world it would have be New Zealand I suppose) and not needing to write this or any other article. But let me share some observations on the current situation.

The markets are encouraged by a number of factors and some of them are a direct result of COVID. Yes, you read that sentence right! Governments’ response to COVID and collapsing economic performance has been to throw a wall of money at the problem. What this means for markets is that interest rates will stay lower for longer (Possibly measured in years) than pre COVID expectations which is very good news. Also, it is obvious that there has to be a greater tolerance politically for the massive debts that governments are building up. Government stimulus will be the order of the day for awhile.

What about the impact on business and profitability of COVID? Why won’t that destroy equity prices? The simple answer is that in some cases it has and will. The divergence in performance of the better performing stocks on Wall Street in 2020 such as Amazon compared to poor performers like, Exxon, was both massive and very extreme by historical standards. I think it is safe it assume that whatever happens to the overall level of indices in 2021, this marked difference between winners and losers will continue. In the 21st century one of the major problems facing western economies has been chronically poor productivity and one of the silver linings of COVID is that the acceleration of automation and digitalisation has begun to provide an answer to this previously intractable issue. Companies that can anticipate and adjust to changing circumstances in business and consumer behaviour will benefit and of course the reverse will sadly also apply

Another reason why markets appear disconnected from the present state of the world is that pricing is not a function of today’s conditions but of what things will look like sometime in the future. There has never been a clearer example of this disconnect than on 6 January this year. While rioters were storming the Capitol building in what many have called an attempted coup, the S&P went up by over 400 points! At first glance this seems crazy but in fact it was a rational response to what happened earlier that day. By winning the two Senate seats in Georgia, the Democrats had gained control of both houses of Congress which will enable President Biden to go forward with his ambitious economic stimulus without interference. So the riot was dismissed as “noise“, but the Georgia result was seen as a “signal“ with market consequences

So what could go wrong and blow the cosy consensus of low interest rates, benign inflation and post COVID economic recovery off course? The answer: a lot!

The markets and maybe the world as a whole, are anticipating that vaccines are the “silver bullet“ that will defeat COVID. Let’s hope that is right. However it is extremely unlikely to be a smooth ride and it is already obvious that countries are going to come out of this crisis on different timescales and these timescales have no certainty about them. the opportunity for the timings to slip beyond market expectations are obvious with knock on effects for economic performance and profitability. During COVD we have seen the sharpest volatility in economic data for centuries, this is likely to continue in 2021 and distinguishing “noise“ from “signal“ will be both important and difficult

Analysts are assuming that the huge monetary stimulus we have seen will feed through positively to the economy without creating inflationary conditions. Maybe, but there is a real danger that commentators have underestimated the inflation caused by businesses having to reconfigure to accommodate COVID. In a more local context, a lot of emphasis has been placed on the likely added contraction of the UK economy created by Brexit but maybe not enough focus has been directed to the inflationary pressures that Brexit will release in the UK and Europe. There is a real danger that inflation is not dead but merely sleeping! Any sign of a reawakening will really spook markets.

Personally for me the greatest threat to the markets are their current valuations. I always keep any eye on the equity risk premium which compares the price of equities to bonds. Currently this data makes equities look very expensive and of course bond valuations are very stretched as well. However a couple of health warnings are in order here.Firstly I had this view six months ago which demonstrates that massive liquidity can and did in 2020 overrule conventional valuation matrix. Secondly in 40 years of investing I have only learnt one thing and that is I know nothing! So be warned!

However before leaving the subject of valuation I am struck by the words of the great American diplomat George F Kennan who said ‘a lot of people have thought very hard about human affairs for a long time and may have done a lot of work that we need not repeat’. He went on to suggest that we should use this “credit balance of experience and wisdom “. I am very struck by these wise words when I hear people say things like value investing is dead. Out of fashion and maybe for quite a long time, but dead? I doubt it.

An article such as this cannot do justice to all the issues and challenges that people in the investment world face in 2021 and I am particularly struck that some of the most serious issues to be grappled with will not be resolved in 2021 but further out into the future. What will be the long-term scarring effects on the economy of COVID and in the UK of Brexit? Can the capitalist system adjust successfully if liberal democracy is running out of road? Can the world overcome the challenges of climate change? These are important questions that go far beyond the scope of what I am writing about today but they will require answers on another day.

To everyone involved in the investment industry I want to congratulate them for surviving in 2020 whatever your role and wish you all the best for the coming year. Those who have never been involved at the sharp end often fail to appreciate what a difficult task it is to thrive in the investment industry and for those of us who are no longer involved day to day, we salute you. I am reminded of a wonderful analogy written by the late great Barton Biggs.

“What is the difference between a dog that has been run over by a truck and an investment manager? You can see the skid marks on the dog!“

2021 will be a year like most others; it will be very important to dodge the trucks. Good luck!

About the author: Nick Watts’ executive career was focused on the investment and pensions industry. His early roles included senior positions with Rothschild, Citibank and HSBC before spending 12 years with Watson Wyatt (now Willis Towers Watson) as Head of Investment Practice for Europe. Nick’s non-executive career has included numerous Chair and Senior Independent Director roles including; Chair of the Investment Committee for Cable and Wireless Pension Fund (£2bn fund), Chair of Corporate Governance and SID for Legal & General Investment Management and Chair of Biotics PTY Ltd, a growth stage biotech company. Nick is also currently Chairman of Forster Chase Executive Search and a Non-Executive Director of Forster Chase Corporate Finance.