Q4 2020 CIO Review & Outlook
CIO Robert Horrocks, PhD, reviews a topsy-turvy 2020 and shares the reasons for his relative optimism for Asia and the emerging markets in 2021.
I don’t know if I have ever experienced such a strange year. Perhaps that is a common sentiment. However, I refer less to the lockdown. Nor do I refer about work so much. We were able to keep in touch with each other through technology and socially distanced face-to-face meetings. Through the same use of video conference calls, we were able to maintain contact with companies, both familiar and new. We were able to adapt—we were given lemons and we made lemonade. In many respects, performance of the portfolios has been excellent; so it is hard to see how the environment disadvantaged our investors. Nevertheless, our investment team are all to be congratulated by the way they responded to the environment and continued to make decisions on behalf of investors.
No, none of that has been too strange. But the markets themselves? There, I do pause for thought. Given the set of circumstances we have faced—political, economic and emotional—I would not have expected markets to do so well. So, why have they?
Perhaps we need to go back to the beginning. Our first reaction to the virus was one of optimism. China had faced things like this before and had dealt with them. In the past, such episodes had little long-term effect on the markets. This turned out, in hindsight, to be more or less true for the current virus, but only for China, which reacted in a way largely consistent with previous outbreaks. For the rest of the world, however, it didn’t start out that way. The economic effects of the lockdown hit hard on expectations of current sales and profits. Only in the virtual world were businesses somewhat protected from the worst, as people could transact with total physical distance.
The virus spread far wider than previous outbreaks and the economic effects were deeper and longer-lasting than we ever suspected. And yet, the idea that this was a temporary disruption to the general trend of economic and human progress has never really gone away. Markets were able to see through the near term and still believe in a “normal” future. So, when the dampening effects of weak current economic activity and raised household savings caused bond yields to fall across much of the world outside of China, valuations soared. After all, if you are able to discount a normal future at abnormally low interest rates, then price-to-earnings ratios should be much higher. So, the equity market saw a positive future while bond yields were suppressed by low demand for goods and the persistent lack of demand for new investment that has been a commonplace of recent years.
And so it has been a topsy-turvy world in many ways. Perhaps white is the new black—“watch out when things get better, they may get worse!” In any other year, I might feel self-conscious writing such phrases; but not this year. For I can see it is entirely possible that, in the face of a vaccine and a recovery in economic activity, bond yields may rise again and those valuations that seemed justified may suddenly become unrealistic. Now, how much of a concern is this?
It’s undeniable that some of these valuation effects have helped performance in investor portfolios this past year. However, I feel these effects are mitigated by several factors. First, of course, we are aware of these effects and always strive to own securities whose valuations we believe are justifiable in the face of their long-term business prospects. Second, we have been trying to take advantage of those businesses which have suffered most from the direct effects of the lockdown. In our opinion, these are not poor businesses but businesses that many investors have overlooked simply because they have been fascinated by the momentum elsewhere. And finally, when we look at the strange interaction between weak activity, collapsing bond yields and high valuations on weak profits that has been the heady, if startling, recipe of 2020, it is perhaps least in evidence in China—economic activity has bounced back earlier and stronger than elsewhere and bond yields are, for want of a better word, “normal.”
As I look into 2021, the dislocations in the markets that may happen from a return to normality may be more keenly felt in those markets where normal conditions have been suspended the longest. It’s not hard to imagine a vaccine-inspired end of lockdowns in the U.S. and the West leading to a burst of inflationary pressures as demand returns more swiftly than supply, people pay down precautionary savings and enjoy a return to normal spending patterns. My expectation in such a case would be for bond yields to rise and valuations in the most extended parts of all markets, particularly the U.S. and Europe, to revert to something more normal. However, my relative optimism for Asia and the emerging markets extends beyond these short-term effects. For, in the U.S. we have already seen the first suggestions of a return to more friendly policy internationally, a more pro-labor stance and an administration likely to be supportive of fiscal and monetary expansion. All of this brings the U.S. belatedly in line with some policies that have already been prevalent in Asia for the past decade, to the detriment of Asia’s relative market performance but the benefit of the internal stability of their societies.
The common perception among asset allocators, both in the U.S. and abroad, appears to be that a period of a slightly weaker dollar is the most likely outcome in the currency markets. There is a renewed willingness to look at international markets in general and emerging and Asian markets in particular. I wish the fortunes of these markets were not so tightly tied in the short-run to the direction of the U.S. dollar, but that seems to be one constant of the world. I believe it is a relationship that will gradually weaken along with the continuing development of China’s own capital markets and the likelihood that it will continue to be an international investor. Nevertheless, a weaker dollar, if that is indeed to happen, is an important tailwind for our markets.
And if a weaker dollar should focus investors’ attention a little more on the long-term trends we seek, so much the better. We still believe that one can prosper over the long term by finding businesses that are the leaders of the development of a world class health care industry, indigenous innovation in technology hardware and online business models, the growth and domination of local brand leaders in more traditional business, and the modernization and development of capital markets to support efficient and sustainable growth for more than half the world’s population. So, even in a topsy-turvy 2020, and maybe a turvy-topsy 2021, that is what we will continue to try and do.
Robert Horrocks, PhD
Chief Investment Officer