The phrase "May you live in interesting times" is claimed to be an ancient Chinese curse. While the origin of the saying is in dispute, its meaning is clear, as is its applicability to the present.
We do live in interesting and challenging times -- as humans, parents, citizens and investors. And while the darkness of disease, economic strife and political upheaval still hangs over many corners of the World, I have to believe that it is in times such as these when character is revealed and greatness achieved. There is room for optimism despite these very real challenges.
ARE MARKETS AMORAL?
Strangely, many investors have prospered despite this overhang. Markets are brutal arbiters of financial truth, relying on numbers and probabilities as opposed to judging the qualitative aspects of life. "How will a company's earnings be impacted?" is among the only questions that investors collectively asked. And the answer that came back was straightforward: "They won't be hurt all that much."
Here's why that is true: Of the top ten companies in the S&P500, five are technology companies that passed through the pandemic largely unscathed. Sure, the retail, hospitality, travel, energy and financial sectors have yet to return to their pre-pandemic levels, but these account for only a quarter of the value of the index. The simple math shows that it's fully logical for the market to be "up" while surrounded by high and resurgent unemployment in a society that requires a moratorium on evictions and whose citizenry relies on robust donations to food banks. These factors are hardly connected for some companies.
Put another way, markets are amoral (not to be confused with immoral), seldom passing judgement on human impacts until they affect financial results. The markets have correctly forecast an economy that is on the mend in 2021. And in fact, many economists foresee a strong snapback this year, with real GDP growth of 5%, or more. As we highlighted in November of 2020, such "reflation" would likely result in a shift in market leadership as investors turned their sights towards those areas likely to experience higher growth. (These projections are, of course, dependent on a swift rollout of vaccines to about 75% of the population, thereby slowing levels of transmission of the COVID-19 virus.)
POSSIBLE LEADERSHIP SHIFTS
We have already started to see this tug-of-war between the growth stocks (and tech sector) that have worked so well and the long-suffering "value" stocks (in the more economically-sensitive sectors such as finance, industrials and basic materials.) Additionally, European stock markets have a higher percentage of companies in such sectors, and an overvalued dollar might be a wind at their back. Valuations are more attractive overseas, and value investment styles have even more "value" than has been typical historically, suggesting an overshoot that will be corrected over time.
Sustainable (ESG) strategies had a good year in 2020, with far more than half of sustainable mutual funds outperforming their peers. Surely, the recent "light blue wave" will provide support for renewable energy and infrastructure sectors, but the broader shift by investors towards companies who meet higher Environmental, Social and Governance standards is here to stay (and will continue to grow.)
DEBT AND TAXES
Many investors have asked whether or not one should be concerned by rising federal debt levels. The short answer is that it will matter when it matters. For now, the markets want to see fiscal stimulus since it provides support for lower income consumers, who then are less likely to default on debts and are more likely to spend on necessities. The short term outweighs the long term for a while.
Countries have occasionally had higher debt-to-GDP ratios than those the US has now. (Usually in wartime.) But debt doesn't necessarily have a direct connection to corporate earnings until it impacts overall levels of inflation and interest rates. We expect those to tick higher, but not materially. Refinance your mortgage, if you have one.
Lastly, taxes are on the minds of investors, and rightly so. The light blue tint to politics means that big tax rate changes are not highly likely, especially with the economy still weak. But wealthier taxpayers are likely to see higher rates over time as the most recent tax changes had favored both corporations and those in the highest brackets. With US borrowings now at nearly 100% of GDP, other sources of revenue will be needed.
Minimizing taxes, therefore, will be key. Tax efficient strategies, such as those using Exchange Traded Funds (ETFs), will be favored over traditional mutual funds (who are forced to distribute capital gains when they are realized inside the fund.) ETF investors only incur capital gains when they sell the position.
Furthermore, asset location will be as important as asset allocation. Placing tax-inefficient strategies, such as hedge funds and high turnover stock funds, in tax deferred accounts will be especially important in coming years. For taxable accounts, we advocate building a core ETF portfolio that will seldom change, while placing tactical positions in one's tax deferred accounts. Minimizing trading of core positions will permit them to compound returns over time without giving up part of the return to capital gains taxes.
Long term alternative investments, such as private equity, should continue to be preferred strategies since nearly all of the returns will be in the form of tax-efficient long term capital gains.
Putting it all together: The proliferation of hundreds of ESG strategies with ETF structures permits investors to build tax-efficient portfolio with the social characteristics that they demand, without sacrificing performance over the long term. Proper use of tax exempt accounts will still allow investors to diversify among complementary strategies to take advantage of shifts in growth characteristics and valuations. Growing global economies in 2021 will be the main drivers of investor interest, possibly offset by high valuations and modestly rising interest rates.