Vaccine Driven Light at the End of the Tunnel?
Introduction
2020 will be a year not soon forgotten. The historic year that seemingly had no end did in fact end. As we cautiously turn to 2021 with optimism that the worst is behind us and there is a light at the end of the tunnel, driven by the hope that the successful rollout of various vaccines allows society to move past the Covid-19 pandemic permanently.
Before looking ahead, we first look back once more to 2020, where the experience of global financial markets seemed to disconnect from the economic reality faced by most of the population. This is unquestionably due to the swift responses of central banks and governments globally to inject massive quantities of fiscal and monetary support into the financial system.
Discerning what changes to financial markets, global economies, and society are more permanent shifts versus lockdown specific will be important when it comes to allocating capital for the future and the new normal we will enter on the other side of this pandemic.
Fixed Income
As risk on sentiment and vaccine optimism surfaced following the US election in November, we saw yield curves respond to increased growth and future inflation expectations. This can be seen in the steepening of the yield curve in both the US and Canada over the quarter, shown in the pink and green lines in the following chart.
However, it is worth stepping back and looking at where rates were on December 31, 2019 (red line). Rates have come down across the board over the course of 2020, as a mix of recession, central bank rate cuts, and flight to safety all contributed to a move lower in rates. This shift down in the yield curve resulted in strong government bond returns for 2020, particularly in the longer duration, as evidenced by Chart 2 below, with the red line in Pane 1 and grey line in Pane 2 showing longer government bond ETFs outperforming peers.
Credit spreads continued to drift tighter, ending 2020 around similar levels to how they entered the year and recouping most of the rapid widening move that occurred during the March market selloff. Monetary and fiscal stimulus and bond buying programs have no doubt contributed to this, with loose financial conditions allowing companies to continue to service and/or roll over their existing debt. This also allowed credit markets to stage a strong recovery from the depths of March as evidenced in Chart 2.
Equity
The final quarter of 2020 saw continued strength in global equity markets, particularly during November following the US election, with vaccine optimism providing a platform for risk-on sentiment and providing a lifeboat to sectors that had been left behind during the initial recovery phase. We had commented on the fact that there was a clear distinction between winners and losers in 2020 in previous newsletters, and the potential for some mean reversion of this as we emerged on the other side of the pandemic. On the below chart looking at the major global sector ETFs, we see that Energy, Financials and Materials were leaders through November and December to that point. With risk on sentiment since the March lows, the US Dollar weakened year over year against the Canadian dollar, ending the year down close to 2%, and over 12% below the levels seen at the bottom of the markets in March.
A further outcome of this move was the outperformance of international and emerging markets versus the US, which had been the main driver of the initial recovery from the March low, led by US technology. 2020, and most of the last bull market, have been led by Technology, as evidenced by the outperformance of the Nasdaq in Panes 2 and 3 in the chart above. We have touched on many of the valid reasons why in previous editions, but the main thing investors will be watching is how much of the demand-pull stemming from the pandemic during 2020 is a permanent shift for these businesses or was a temporary pull forward. We will touch on this further in our commentary surrounding our current outlook.
Outlook
The major story as we enter 2021 will be centered around vaccines. The combination of their effectiveness at halting infection, and the effectiveness of the rollout and distribution globally are both critical components to allowing global economies to re-open. We continue to expect that there will be strong consumer demand unleashed as this reopening of global economies and societies occurs. In this environment we would expect to see a continuation of trends from the last quarter, with rates in the fixed income world creeping higher, particularly on the long end of the curve, and broader leadership providing for healthier and deeper equity markets globally.
We continue to favor keeping overall fixed income portfolio weighting at the lower end of mandate ranges. This is driven by the current low yield and rate environment globally providing a low starting point for return expectations from bonds and credit. Moreover, because of the risk of rising longer term yields stemming from a global economic recovery, we continue to favor a shorter duration in the fixed income sleeve of portfolios to protect capital.
At some point equity investors will need to see fundamentals of companies begin to justify the recovery that has been priced into equities during the recovery from the March lows. As such, developments around the slow deployment of vaccines or changes to the expected effectiveness of them, pose risks to this recovery expectation and will need to be monitored closely.
A second major story as we enter 2021 revolves around the political landscape in the US. At the time of writing, the January 5th runoff elections in Georgia will see both Senate seats flip to Democrat candidates. This would see control of the Senate flip blue, with VP-elect Harris providing the tiebreak once the government changes over on January 20th. This would mean that all three houses of US federal government would be under Democratic control.
Certainly, this increases the range of policies President elect Biden could seek to deliver in the coming years. However, the Democrat majority in the House and Senate are both quite thin, as such we would expect policy to be more center of left than hard left, which will likely frustrate the more progressive members of the Democratic Party. We would expect fiscal stimulus from President Biden, both in the form of increased benefits to the population, and through fiscal programs aimed to generate jobs and economic activity to be initial priorities.
We would expect a focus of these programs to be infrastructure based, with attention and incentive given to climate goals and the usage of renewables. Since the election, the renewables segment of the global infrastructure universe has seen extremely strong price moves in anticipation of this focus from the new US government under Biden. It will also bear watching how the new US government proceeds with global trade strategy, taxation, and regulation of business, particularly the technology and consumer giants who have come under increased scrutiny.
Overall, we will always continue to maintain a disciplined approach to constructing and maintaining portfolios, prioritizing high quality businesses with strong balance sheets and cash flows while managing overall risk and asset exposures. We continue to maintain focus and conviction on secular themes that we feel will be major shapers of the next decade, as well as continuously evaluate new ideas.
2020 saw many of our core thematic ideas exhibit continued growth throughout the pandemic, which we take a further validation of the investment theses underpinning these trends. Areas like cybersecurity, medical devices, mobile payments, and e-commerce all showed strong resiliency in the face of a challenging year and looked poised to continue to demonstrate increased usage, value, and demand into the future.
As we emerge from this pandemic, the world will return to normalcy. However, it is unlikely that normalcy in 2021/2022 will be the same as in 2019. The world has undoubtedly shifted and changed because of the events the COVID-19 pandemic brought about. Governments, businesses, and people globally are all scrambling to adapt, and our portfolios will continue to adapt in response.