INTRODUCTION
Stimulus measures throughout the year have helped valuation multiples grow richer, despite a collapse in corporate earnings and economic fundamentals. This dynamic underlines the biggest source of market returns this past year: the expansion of valuation multiples.
In the fourth quarter, positive developments of a coronavirus vaccine improved market sentiment even further, forming the basis for a sustainable return to normalcy and sending stocks even higher. More so, this helped unleash a powerful “pro-cyclical” rotation, and value stocks substantially outperformed growth stocks.
We were able to again outperform in this market environment, aided by changes in portfolios, including taking profits from some high valuation “winners” and redeploying to lower valuation holdings. On the margin, we believe these changes should help mitigate some downside if markets become less hospitable or if the rotation from growth to value persists. We continue to contemplate further adjustments for a more conservative balance of growth, profitability, and valuation in the portfolios.
We thank you for entrusting us with your precious capital. While some uncertainties are resolving, we remain wary of the risks to the market rally, including elevated valuation multiples, over-reliance on central banks, an uneven or shallow economic recovery, and resurgences in coronavirus cases. This is an unprecedented market environment, and we are hard at work navigating these uncertainties. Our investment process is selective and identifies durable and high-quality growth companies, which we believe can ride out and, in many cases, grow through difficult times such as this.
MARKET UPDATE
New vaccine developments, such as efficacy results, initial distributions, and confidence on supply, improved market sentiment substantially. Some degree of coronavirus optimism had been baked into recent market returns, but nonetheless, vaccine news sparked another leg of the rally. Furthermore, market leadership rotated from growth and momentum factors to value and cyclicals. This rotation highlights the potential for a more broad-based rebound in fundamentals, but it was also exacerbated by relative valuation differences that had expanded consistently since March.
Pandemic cases surged in many parts of the world, causing governments to prioritize public health and reissue containment measures. Overall, restrictions are less strict than those imposed in the initial phase of the pandemic. However, they are headwinds for a limping economic recovery, and there is skepticism whether they can direct any sustainable downward trend in cases. Most economies, both developed and emerging, shrunk in 2020; the two notable exceptions are China and India, which grew modestly.
Significant political uncertainty has been removed after the U.S. presidential election. President-elect Joe Biden defeated President Donald Trump but in a much closer fashion than was anticipated. Overall, markets warmed to the prospect of the Biden administration, though control of Congress will be decided in a pair of runoff elections in January. In the more likely case that Congress is split, then a divided government would be less likely to disrupt pro-business tax and regulatory policies. On the other hand, if Democrats control Congress and complete the “blue wave”, then a single-party government would be more likely to enact more robust fiscal stimulus and a coordinated coronavirus response. Either way, the Biden administration is expected to deescalate global trade tensions accumulated during the Trump administration.
The policy environment remains supportive, and both monetary and fiscal stimulus have limited the economic impact. The Federal Reserve (Fed) left policies unchanged but reiterated its commitment towards monthly asset purchases of $120 billion and zero interest rates until it achieves progress towards maximum employment and price stability. Given both these
goals are still far off, conviction is high that monetary policy will remain ultra-accommodative in the near-term. Furthermore, the Fed retains $750 billion of dry powder to backstop markets in the event of another disruption under its current pandemic stimulus authorities. With respect to fiscal policy, President Trump signed into law a new coronavirus stimulus package, something that had been a political stumbling block for many months. The new package is worth $900 billion, with the largest tranches earmarked for small business relief, another round of direct payments, and additional jobless subsidies.
Eurozone interest rates were left unchanged, but the European Central Bank (ECB) reinforced its accommodative monetary stance through several measures. Most significantly, the ECB expanded its Pandemic Emergency Purchase Program by an additional €500 billion (approximately $610 billion), taking the total envelope of the program to €1.9 trillion (approximately $2.3 trillion). Additionally, the ECB loosened already generous terms on long-term funding available to banks, increasing the cap on this program and reducing collateral requirements, as a way to stimulate lending to the real economy. Both the Bank of England and Swiss National Bank kept policy settings unchanged.
On the side of fiscal policy, European Union (EU) leaders approved the largest stimulus package ever. Collectively, this included a long-term budget for 2021-2027 and a short-term emergency recovery program worth €1.8 trillion in total (approximately $2.2 trillion). This package also has a special focus on funding faster green and digital transitions in Europe, which are two important investment themes we are already participating in with portfolio companies and continue to do further work on. Last, this package also paved the way for the EU to set ever more ambitious goals on climate change, now targeting cutting greenhouse gas emissions by 55% by 2030 compared to 1990 levels.
The UK and the EU reached a Brexit trade deal, bringing to a close years of economic uncertainty and fraught politics in the UK and calming the fears of a major economic disruption. Under the terms of the deal, both sides will continue to trade free of tariffs but there will be significant new bureaucracy for importers and exporters. The free flow of workers between the two economies will end and trade in services will be much reduced. The deal gives the UK significant freedom to depart from EU regulations and sign free-trade deals with other countries. But as the price for securing a deal without tariffs, the UK agreed that it would not seriously undercut EU standards on issues such as labor and the environment and would maintain similar constraints on the subsidization of private industry. The deal will result in greater friction to trade, making it a real-time experiment in deglobalization, as the UK formally exits from the EU’s single market union.
OUTLOOK
Due to the vaccine developments, the most likely economic scenario is one that improves in the next year. And almost certainly, we have averted a disaster scenario in which the pandemic continues to grow unchecked. As the vaccine is administered to larger swaths of the population, herd immunity will increase, and the spread of the disease will decline. Vaccine manufacturers have announced expected availability in the billions of doses. The most uncertain aspects pertain to how much reach in the next year medical professionals will actually have administering the vaccines, and when emerging countries can obtain their share.
Central banks have become much more optimistic about a rebound, albeit shallower and choppier than originally anticipated, in the next year. Many macroeconomic indicators have stabilized and are no longer deteriorating, with the exception of services and consumption data that are more sensitive to weakness in domestic economies. However, the recent resurgence of coronavirus cases is expected to have follow-through effects on near-term economic growth. And while downside risks have been reduced in recent months, the most likely risks pertain to renewed containment measures. The availability of the vaccine is positive for the economic outlook and is further assisted by ongoing supportive measures by central banks and governments.
Monetary policy will continue to be an important component of the market narrative, but a depleted arsenal and general fatigue also play into worries that monetary policy is increasingly pushing on a string. Therefore, fiscal policy will play an even more critical role for supporting economies in these difficult times. Fortunately, recent important fiscal stimulus packages were passed and made it through political gridlock.
The rotation from growth outperformance to value outperformance was not terribly surprising. The interesting question is whether the rotation might be sustainable, especially as recent instances of growth to value rotations have tended to fizzle. The case that value stocks have more room to run revolves around expectations for more positive vaccine developments and a rebound in corporate earnings. Furthermore, cyclical sectors should be a beneficiary of the economic reopening. Valuation differences between growth stocks and value stocks are still near their widest point over the last ten years. And overall, market valuations have become expensive relative to current earnings power, and they are likely to stay elevated next year as central banks continue to ease into the recovery.
While valuations are high across the market, on a relative basis, they are still most attractive for international stocks. The pandemic has delivered a global growth shock, but in doing so, it has accelerated the timeline for several mega trends that we have been actively investing in, such as productivity enhancement (robotics, automation, and software), e-commerce, electronic payments, and rapid drug development. Furthermore, many portfolio companies have been able to continue to deliver growth even in this recessionary environment, which is an exceptionally rare trait.
We have made adjustments to portfolios, including realizing profits from some high valuation “winners” and redeploying to lower valuation holdings. On the margin, these changes should help mitigate some downside if markets become less hospitable, and we continue to contemplate further adjustments for a more conservative balance of growth, profitability, and valuation in the portfolios.
https://chautauquacapital.com/
For additional important information about the fees, expenses, risks and terms of investment advisory accounts at Baird, please review Baird’s Form ADV Brochure, which can be obtained from your financial advisor and should be read carefully before opening an investment advisory account.
The above commentary does not provide a complete analysis of every material fact regarding any market, industry, security or portfolio.
©2021 Robert W. Baird & Co. Incorporated. Member SIPC.
Robert W. Baird & Co. 777 East Wisconsin Avenue, Milwaukee, Wisconsin 53202
First Use: 01/2021
Read more commentaries by Chautauqua Capital Management
