4th Quarter 2020 Market Commentary

In preparing for battle I have always found that plans are useless, but planning is indispensable.
– Dwight D. Eisenhower

The successful launch of two separate vaccines accelerated the recovery in the equity markets during the quarter, leading the S&P to end the year with a return of 18.4%. With an end to the pandemic in sight, value outperformed growth during the quarter. The Russell 1000 Value Index gained 16.2% compared to the 11.4% return for the Russell 1000 Growth.  US small cap stocks returned over 30% in the quarter, leading them to outperform for the full year. Foreign stocks also outperformed during the quarter.  Energy and Financials, two of the worst performing sectors during the first three quarters of 2020, were the best performing sectors in the S&P 500.  Speculative growth stocks continued to dominate, driven by the 31.4% return of Tesla, which brought its 2020 return to a staggering 743%. This combination of outperformance from both speculative growth stocks and formerly distressed value names, led to an over 10 percentage point underperformance of high quality stocks relative to low quality. This created a significant headwind for our investment managers who focus on owning quality businesses.

Although the pandemic continues to set record new caseloads and deaths, the rollout of the vaccine offers clarity on what the second half of 2021 may look like.  After the pandemic ends, a surge of pent-up demand for personal travel and entertainment should provide some economic relief.  However, many aspects of 2019 life, particularly business travel and commuting, will remain under pressure, providing little relief to industries dependent on these activities.  While no doubt people will want to take vacations again, business travel accounts for 20% of total spending in the hospitality and travel sector and approximately 70% of revenues for high-end hotels[1].  Business travel after past recessions lagged recoveries in personal travel.  International business travel took five years to recover after the 2008-2009 Global Financial Crisis.  Similarly, a recent survey of corporate Chief Information Officers by KPMG found that nearly half of businesses expected 20-50% of their workforce to work predominantly from home on a permanent basis, with an additional 24% of respondents expecting over half their workers to remain home[2].

An abnormally slow recovery followed the 2008 Global Financial Crisis.  Two major drivers of US economic growth from 2009 to 2011 were exports to China and fracking.  China provided an under-appreciated boost to the world economy with a record fiscal stimulus package that equaled over 12% of the country’s GDP.  Most of the funds went to infrastructure and real estate, driving global demand for commodities and construction equipment.  US exports to China increased by approximately $40B between 2009 and 2012, a 57% increase.  The NBER estimated that fracking created 750K jobs, reducing the US unemployment rate by 0.5% during the recession.[3]  As neither a major expansion of employment in the oil & gas industry nor a repeat of China’s 2008 stimulus appears likely, what will drive the US economy over the next several years?

The technology investments made during 2020 should continue to add to corporate profitability over the next several years.  Work from home required a major investment and revision of policies and procedures that, for most businesses (ours included!), resulted in dramatic productivity gains.  Less obvious are investments in data security, automation and supply-chain transparency and flexibility.  US productivity posted its largest six-month improvement since 1965, increasing 10.6% in the second quarter and 4.6% in the third[4].  The McKinsey Global Institute estimates that over 20% of the global workforce could effectively work from home the majority of the time.[5]  These gains can boost the profitability of a wide range of companies, not just a small set of favored growth stocks.  What does this mean for future employment? A primary reason given for the slow pace of hiring coming out of the 2008-2009 Global Financial Crisis was that companies, after being forced to do more with less people, found that they could.  A similar risk exists that this productivity increase will create employment headwinds.  This could exacerbate existing tensions surrounding income inequality, creating a new ‘digital jobs divide’, fueling populism and potentially destructive economic policies.

Asia led the world in its response to the pandemic, and consumption by its growing middle class will be a major driver of the global economy.  According to a recent study by the Brookings Institute[6], 54% of the global population that met their threshold of middle class ($11-100 per person per day in 2011 purchasing power) resides in Asia.  They project this proportion will increase to 65% by the end of the decade. In dollar terms, Brookings estimates Asian middle class household consumption reached $20T last year – about the size of the entire US economy.  By 2030, this number should grow to $36T, which equates to a 6.1% annual growth rate.

The pandemic revealed both significant gaps in healthcare and the promise of emerging technologies in the sector.  Biotechnology showed its promise during the pandemic. Modern technology sequenced the COVID-19 genome and published it on the Internet on Jan 23, giving a head start to vaccine development efforts.  Past vaccines have taken years to develop.   The radical new mRNA vaccines were developed in record time. Rather than using a dead or disarmed live virus like traditional vaccines, the new Pfizer and Moderna vaccines directly program the desired immune response.  This technology, by the way, has applications to cancers and other diseases.  Biotechnology’s capabilities stand to be radically enhanced by a conflux of artificial intelligence and big data with new advances in bioscience.

Democratic control of Congress will accelerate the current trend toward renewables and the electrification of transportation.  A Rocky Mountain Institute study projects approximately half of current conventional power plants will be retired by the 2030s, as they reach the end of their usable life.  Solar and wind currently offer both the most cost competitive and politically feasible solution to replace these assets.  These two technologies currently generate about 10% of the country’s electric power.  In three states – Kansas, Iowa and North Dakota – wind and solar account for over half of total electricity consumption.  Advances in batteries facilitate a higher proportion of wind and solar and also spur the electrification of transportation.  In the US, petroleum has a negligible role in electricity generation and is primarily used for transportation.  Electric vehicles have made inroads, but widespread acceptance depends on offering consumers the larger trucks and SUVs they prefer at a better value proposition.  Advances in battery technology and falling production costs as more electric vehicles are produced, will likely enable automakers later this decade to offer EVs with lower prices than similarly equipped conventional vehicles.

The themes discussed here do not require new investments; these opportunities all fall within the scope of our existing managers. Caution is warranted.  Many stocks related to the themes above saw astronomical returns in 2020, with Tesla’s 743% return setting the bar.  The re-emergence of 1990s style day trading, boosted by social media, created an environment where the primary rationale for stock purchases appears to be simply that the price is going up.  In the past, hot ‘concept’ stocks that lack the support of a rational valuation lost 90% or more of their value once they fell out of favor.  These losses can happen even to companies that survive and emerge as winners – Amazon.com, for example, declined 91% from March 2000 to September 2001.  Similarly, not all economic activity generates good investment opportunities.  In the early 2000s, the buildout of the fiber optic backbone of the Internet ended with the bankruptcy of most of the companies involved.  Similarly, the fracking revolution in oil and gas generated net losses for investors.

While the events of 2020 thwarted any conceivable plan in place at the start of the year, good planning allowed investors to maintain their portfolios in the face of a global disaster and record volatility in the financial markets.  Markets exhibited extreme volatility adjusting to the onset of COVID-19 and the accompanying fiscal and monetary policy responses.  Planning regarding asset allocation and sources of liquidity provided a toolset to financially navigate the pandemic and proved invaluableUnlike the depressed valuations coming out of the 2008-2009 Global Financial Crisis, markets today trade at record multiples.  While current low interest rates may justify higher stock prices, little room for disappointment exists and investors should remain disciplined and wary.

[1] McKinsey, The Next Normal Arrives https://www.mckinsey.com/featured-insights/leadership/the-next-normal-arrives-trends-that-will-define-2021-and-beyond

[2] Harvey Nash/KPMG CIO Survey — https://home.kpmg/xx/en/home/insights/2020/09/harvey-nash-kpmg-cio-survey-2020-everything-changed-or-did-it.html

[3] https://www.nber.org/system/files/working_papers/w21624/w21624.pdf

[4] “Productivity and costs: Third quarter 2020, revised,” US Bureau of Labor Statistics, December 8, 2020, — bls.gov

[5] McKinsey ibid

[6] “The Unprecedented Expansion of the Global Middle Class, An Update” — www.Brookings.edu