2021 markets look confident, but caution required

Returning McWilliam’s Wines to former glory
January 22, 2021

MEDIA RELEASE: Volatility is likely to remain a feature of markets in 2021 as financial markets digest the realities of the far more constrained growth prospects of the real economy, according to portfolio managers at Schroders.

Head of fixed income and multi-asset, Simon Doyle, expects low returns from cash and fixed income assets in 2021 will be a challenge for investors. “Low rates have directly and indirectly dragged down yields across the interest rate and credit curves. We can say with a high degree of confidence that returns from cash and fixed income investments, particularly at the lower risk end of the spectrum will in absolute terms be lousy in 2021.”

“There are opportunities to improve income and returns more generally, but a broad investment universe will be required to identify and implement appropriate strategies. This also means investors need to be more careful about where they take risk, as low sovereign bond yields make it more challenging to hedge risk – particularly equity exposures – elsewhere in the portfolio. It is important that investors use the full capital structure and in particular consider the use of higher risk defensive assets which offer better returns than cash and low yielding sovereign bonds without assuming all the risk of equities. 

“In this environment, defensive currencies and options to mitigate downside risks will also be an important part of portfolio management.

“While volatility will be at the forefront again in 2021, particularly in the coming weeks due to the political instability in the US and the global COVID-19 vaccine roll-out, in some ways this is positive news as it means there will be good opportunities for active asset allocation approaches. 

“Importantly however, investors need to keep a close eye on inflation. While excess capacity in financial markets and the labour market created through the COVID-19 recession will keep a lid on inflation as the recovery takes hold in 2021, the extent to which policy settings are aimed at generating inflation could increase the risk of inflation rising above recent norms in the medium term. 

“This could lead to pressure on bond yields and policy support mechanisms over the medium term, which could threaten the cocktail of support that markets have grown to love and rely on. This would be a catalyst for more structural difficulty for markets.”

Head of Australian equities, Martin Conlon, comments that Australia has obviously navigated the COVID-19 crisis with great success and far lower impact than many of its global peers, but serious challenges lie ahead.

“Equity market returns in the past decade have transitioned from being earnings driven to ratings driven. Expansion in the rating attributed to earnings, or in some case revenues given the absence of profit and cashflow, has become the dominant driver of share prices. This is most evident in technology where multiples and valuations are almost certainly in bubble territory, however, most stocks with perceived growth in revenue and expectations of future profit growth remain priced at levels vastly above historic norms.

“As 2020 drew to a close, the announcements of COVID-19 vaccine rollout plans in major economies sparked a turning of the tide, with many investors seeking out companies with more reasonable valuations. Interest rates offering no further scope for reduction and signs of a greater proportion of money being pumped into the real economy offer opportunity for a reversal of the one-way traffic in momentum investing which has dominated recent years.

“Low interest rates are being used as the persuasive narrative justifying valuations well above historic levels. Evidence in markets such as the US, with long history and reliable data do not support this narrative as profits must necessarily stay attached to the lower growth environment. 

“Businesses significantly exposed to COVID-19 have almost all seen share prices recover to pre COVID-19 levels. Given the substantial lost profits for these businesses, and doubts over whether lost volumes will ever be fully recovered – for instance whether corporate travel will ever return to previous levels – we see limited value in these areas. Food inflation, insurance premiums, solid retail sales and still buoyant housing activity seem to offer some evidence the massive increases in money supply may start to leak into the real economy as lockdowns eventually ease and vaccines impact. 

“Resource and materials businesses are at an interesting juncture. These businesses generally have conservative levels of gearing and are trading at generally low multiples. Commodity prices are varying widely, with iron ore approaching all-time highs and vastly above our assumed long run levels, while many others are at or below our long run levels. 

“While the most attractive opportunities lie outside iron ore, we remain extremely positive on the ability of commodities and materials stocks – including building materials and chemicals – to provide insurance against the possibility of significantly higher inflation, an expectation on which most investors remain extremely complacent, while still representing strong underlying value should this not eventuate.

“Gold, while at levels above our long run expectations, is also an area in which we retain some exposure given the abovementioned inflationary concerns and questions on how investors will react to an increasingly cavalier approach to monetary policy. 

“Forcibly extinguishing yield on cash and government bonds and expecting no ramifications seems wildly optimistic. We do not know how investors will behave when policies instil a ‘cash is trash’ mentality, however, our portfolio strategy remains skewed towards ‘real assets’ and away from purely financial assets.

“While banks have benefited recently from abating bad debt concerns primarily driven by accelerating house prices, we remain concerned over the longer-term future for lending intermediaries in an environment where depositors are expected to provide capital at no return and lending is increasingly competitive. 

“This is particularly the case for long established banks with high cost structures accumulated over many years in more buoyant operating conditions. Additionally, we remain unconvinced bad debts can be eliminated by increasingly detaching asset prices from the income and wages which support them.” 

Mr Doyle concludes: “Uncertainties notwithstanding, there is no doubt markets are entering 2021 in a confident position. But confident investors are not always rewarded. Our own position can be summarised as recognising the positives of liquidity and economic recovery, against the fact that much of this is already discounted. It is an environment that calls for caution but not outright bearishness”.