January 19, 2021
Many readers will be relieved that 2020 is now behind us. While numerous challenges will undoubtedly continue well into 2021, turning the page on a year where so many aspects of our daily lives were upended certainly provided some psychological respite. But does that same feeling extend to investment portfolios? Forstrong mandates generated strongly positive performance in 2020 (per the table below, 5 out of 9 mandates posted double digit gross-of-fees returns). From this perspective, perhaps 2020 was not so bad after all!
But have financial markets gotten ahead of themselves? In recent publications, we have highlighted numerous developments which create a favourable backdrop for risk assets. These include (but are not limited to) a pivot to expansionary fiscal policy, continued central bank accomodation, extremely low interest rates (particularly on a real, inflation-adjusted basis), pent up consumer demand and a weak US dollar. With vaccine deployment emboldening investors, global equity markets have rallied at a torrid pace in recent months. Has all of the good news been “priced in”?
Yes and no. From a shorter-term behavioural standpoint, signs of investor exuberance have emerged and equities are overbought. Stocks may enter a brief consolidation phase before resuming their climb. We would view this as a healthy cooling off period, allowing for a reset of market expectations and draining of speculative excess. Stocks could then realign with their underlying fundamentals, which we expect to improve alongside a recovering global economy.
However, there are pockets within global financial markets where bubble-like conditions have emerged. Clean energy, electric vehicles and cryptocurrencies are all showing signs of significant froth. Tesla is perhaps the most glaring example. Per the chart below, Tesla’s meteoric rise in 2020 (nearly 750% in USD terms) has pushed its market cap above the next 6 largest automakers combined, despite having less than 1% market share in global auto sales. A correction in these asset classes could potentially be much more severe than the “healthy” sell-off noted above.
The good news is that the risk of contagion (spill-over into the broader market) is low. Despite an influx of investor capital last year, these asset classes are still relatively niche in nature and represent a small fraction of global financial markets. A more concerning development would be a sharp downturn in bellwether internet stocks such as the FAANGs, which given their large weight in global equity indices are much more systemically important. However, while these companies had a stellar year and their valuations are somewhat extended, it would be very premature to classify them as bubbles.
All things considered, there is good reason for optimism heading into 2021. With a fertile economic environment, Forstrong has elected to remain overweight stocks (albeit not to the same extent as mid-2020). We have tactically raised fixed income exposure in client portfolios to help protect against short-term vulnerabilities.
GLOBAL STRATEGY OVERVIEW
With broad overvaluation present in both global equity and fixed income markets, cash remains a viable risk management tool. However, the negligible yield currently offered on cash and equivalent positions does not adequately compensate for the increasingly likely prospect of rising inflation. Cash and equivalents have been lowered and are now positioned slightly below benchmark.
Global bond yields remain near historic lows, providing insufficient income and an asymmetric risk profile skewed to the downside. However, fixed income still offers critical ballast to client portfolios, as we enter a period of elevated equity risk. We remain underweight fixed income (and short duration) in client portfolios, but have increased exposure to protect against potential volatility emanating from equity holdings.
COVID-19 lockdown measures gave rise to significant dispersion amongst equity sectors and regions. Internet-based businesses reaped the benefits of a widespread consumer pivot online, while economies in East Asia were able to keep economic activity moving and boost export market share after successfully thwarting domestic virus transmission. With vaccine deployment upon us, the massive performance gap versus other sectors and regions is set to narrow. We have trimmed East Asian equity exposure and maintained overweight exposure to “real economy” cyclical sectors including financials and industrials.
Hong Kong equities have performed poorly as the city has been roiled by political regime change and social unrest, while the government’s fiscal response to the pandemic has been muted (leading to collapsing household income). However, numerous tailwinds have emerged. The Hong Kong dollar’s peg to the US dollar effectively imports significant monetary stimulus and has put downwards pressure on the trade-weighted exchange rate (thus boosting export competitiveness), while the outsized real estate sector trades at historically low valuation multiples and has not yet responded to the collapse in interest rates. We have initiated an opportunity position in Hong Kong equities in balanced and growth-oriented strategies.
Gross-of-fees performance ($CAD) as of December 31, 2020. Returns for periods greater than 1 year are annualized.