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Navigating the markets in 2021

Markets in focus: for investors, there is reason for optimism and caution in the months ahead (Courtney Crow/New York Stock Exchange via AP)

With the turmoil that was 2020 in the rear-view mirror, investors are looking to the future as vaccine distribution begins and the global economic recovery gains traction. In the months ahead, we see reasons for both optimism and caution. On balance, however, we expect the world’s highly accommodative central banks and spendthrift governments to be constructive for risk assets in the near to middle term.

A common theme about the 2020 financial markets was the dichotomy between very strong market returns against the backdrop of rising Covid-19 cases and deaths as we emerge from the pandemic. This contrast is a good reminder that financial markets tend to be forward looking and are currently looking through the crisis to clearer skies ahead.

On the plus side, several positive trends are likely to keep markets afloat. Massive global government stimulus, strong profit growth, widespread innovation and a healthy rotation among market sectors bode well for price action going forward – but expect volatility to remain high.

In terms of profits, analysts are estimating S&P 500 earnings growth of 22 per cent, from $138 in 2020 to $168 in 2021. Notably, this year’s profit estimate is higher than the 2019 level of $161. If analysts are correct, corporations will be more profitable this year than they were prior to the pandemic. The International Monetary Fund expects global GDP growth to rebound by 5.2 per cent in 2021 after declining 4.4 per cent in 2020 from the prior year.

Profitability is important for market performance, but valuations and market sentiment also matter. Until last summer, a handful of well-known mega cap equities had been leading the market averages upwards while commanding generous valuations, but that tide has slowly been turning. The so-called “FANG+” stocks which include Facebook, Apple, Netflix and Amazon began faltering last September. Since then, only Alphabet has managed to outperform the S&P 500, while Facebook and Amazon have actually declined in price. This rotation has allowed the rest of the market to catch up; and now, some of the more cyclical and value priced securities are taking the lead.

Going forward, we anticipate a continuation of this pattern as sectors such as industrials, financials and small cap stocks participate more fully as the economy slowly reopens on the back of vaccine progress. Already, small cap stocks, as measured by the Russell 2000 index have advanced by 8.4 per cent this year, compared to a 2.6 per cent gain by the S&P 500 and 2.8 per cent for the MSCI World Stock Index. Energy, down 30.4 per cent in 2020 was last year’s laggard but has been this year’s best performing sector, up 10.1 per cent so far.

Although value stocks are beginning to show better price action, investors should stay balanced and not completely give up on growth. Many traditional growth stocks should continue to hold their own just as new growth stocks emerge from ongoing secular innovation themes. Key trends such as work-from-home, video streaming, tele-health, remote-learning and faster FDA drug approvals are likely to persist well into this latter part of this decade. In this way, the ongoing disruptive innovation themes already in progress have been pulled forward by three to five years. We expect these themes to continue unabated, albeit at a modestly less vigorous pace.

In terms of disruptive innovation, look no farther than the digital revolution. The World Economic Forum estimates that digital transformation (DX) will unlock $100 trillion in value over the next ten years. A WEF report defines the DX revolution as powered by the confluence of technological waves including cloud computing, big data, artificial intelligence, and the internet of things. Moreover, the cultural aspects of digital transformation may be as profound as the technological and economic impacts.

Clearly, the DX trend already in place has been accelerated by the pandemic. Many of the fastest growing and best performing companies, including several successful IPOs are operating on the DX forefront. International Data Corporation, a global provider of market intelligence estimates that worldwide spending on technologies and services will reach $2.3 trillion over the next two years.

Meanwhile, recent macroeconomic progress is being made and we are seeing an important rebound in trade. Countries such as China, which has been able to control the pandemic, have almost fully resumed manufacturing. Even more encouraging is that firms are beginning to rebuild physical inventories as health concerns remain focused on services rather than goods. Trade matters for global manufacturing and that matters for profits. The leading economic indicators still point to the upside and look encouraging as long as the vaccines are effectively distributed and governments continue to print money and spend without restraint.

Of course, the piper must eventually be paid for the massive government debt used to underwrite the somewhat artificial recovery. The US alone has incurred an additional $7 trillion in debt – an unprecedented 26 per cent increase in just a few months. Incoming President Biden wants to add another $1.9 billion onto the pile in order to pay for his votes. Clearly, today’s politicians are more concerned with near term survival than longer term implications. Putting cash in people’s pockets, even if they already have a job is the fastest route to getting elected.

On the side of caution, Biden has advocated some questionable, if unsurprising programmes which could lead to negative economic, market and social consequences. For example, he has proposed raising taxes in the middle of a recession, further fanned the flames of divisiveness by dishing out favours based on race and gender, thrown away public funds to impeach a former president who has already left the White House. In general, the incoming US administration appears to be following many of Obama’s failed policies which punished America’s working class during his term and ultimately led to Trump’s rise in popularity. However, like wallpaper on the surface of a cracked wall, money-printing can and has provided the illusion of prosperity needed to keep market sentiment moving in a positive direction, at least for now.

Despite the ongoing political dysfunction in the US and abroad, market opportunities can be found by savvy investors. Overall, investors should be broadly diversified among asset classes and sectors. While value stocks may have room to run further, growth companies embracing the DX revolution and other important trends could stay lofty and even climb to higher levels. But still, investors should have cash and bond allocations in order to be better positioned for the inevitable market corrections along the way.

Bryan Dooley, CFA is Head of Portfolio Management at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

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Published January 26, 2021 at 8:00 am (Updated January 22, 2021 at 12:55 pm)

Navigating the markets in 2021

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