by Robert M. Almeida, Global Investment Strategist, Portfolio Manager
The anticipation of fiscal stimulus, along with signs that a vaccine to guard against COVID-19 will be available unexpectedly soon, has boosted optimism, with many now expecting a quicker return to economic normalcy and a profit recovery in 2021. Over the past few months, financial assets with direct exposure to the ebbs and flows of the economy, such as cyclicals and small-capitalization stocks, have outperformed those that benefit from the stay-at-home phenomenon and growth stocks. Similarly, lower equity volatility, higher commodity prices, steeper yield curves and rising inflation expectations all point to the same outcome: reflation in 2021.
As we look ahead, current equity valuations and credit spreads not only imply significant profit growth next year but suggest that today’s stratospheric multiples are sustainable. Against this backdrop, and with little room for error, are expectations for 2021 too high?
What could go wrong?
Early in the pandemic, central banks essentially socialized enterprises’ operating losses in order to forestall a credit crisis and shorten the length of any resulting recession. While this policy appears to have been successful, depending on your perspective, monetary policy is now likely exhausted. In circumstances such as these, central banks lend money, but it’s governments that spend it, putting the onus for future economic growth prospects squarely on politicians’ shoulders.
At the same time, COVID-19 cases and hospitalizations are rising fast in the Americas, Europe and parts of Asia. While hopes for a vaccine help investors envision a more normal future, they can’t solve the current, worsening situation. We fear tightening stay-at-home and social distancing orders may lower mobility and put the thus-far-V-shaped recovery at risk while increasing the already immense need for fiscal support. Although investors have discounted that fiscal help is on the way, its timing and magnitude remain uncertain.
In 2020, equity returns have relied entirely on multiple expansion, given the pandemicinspired collapse in earnings. While such a pattern isn’t atypical market behavior before a recession’s end, its size leaves risk markets vulnerable to unforeseen negative economic surprises or an underwhelming fiscal policy response.
While we have to think about these risk factors, our focus is the business risk profiles in relation to varying potential outcomes — double-dip recession, reflation, stagnation, etc. During the beginning of the crisis and through the recovery, some companies experienced recordbreaking sales comparisons because they were stay-at-home or COVID-19 beneficiaries. Conversely, industries in the crosshairs of social distancing experienced intense financial pain.
But it’s important to not get whipsawed by headlines or extrapolate too much from the recent past. That’s what machines do, not investors. Investing is thinking through what just happened and determining if events have altered the underlying strength or weakness of a business, then ascertaining what the cash flow profile may look like over the next several years and ultimately what that cash flow is worth.
In a recent internal research meeting, MFS Chief Sustainability Officer and Portfolio Manager Barnaby Wiener remarked that “real risk often hides in plain sight.” To me that meant sometimes risk can’t be measured in an Excel spreadsheet. While markets always lack complete information and uncertainty is always high, valuations today suggest a lot of confidence about the range of outcomes in 2021.
Responsible investing is financial sustainability across multiple dimensions
As I reflect on 2020 and look ahead, my mind keeps coming back to the purpose of financial markets — price discovery and the efficient allocation of resources. Investors assess the return prospects of an investment against its risks while weighing the opportunity costs versus comparable investment opportunities.
At MFS, our purpose is to underwrite these risks and then allocate capital responsibly. While investing has never been easy, today’s environment has raised the stakes.
For myriad reasons, there are always flashy investment opportunities with attractive return prospects, ever more so given today’s near-zero interest rates on savings. But we have to ask ourselves how many things have to bounce right for these ideas to live up to expectations. Can a business survive a double-dip recession? Does it have enough liquidity if faced with another credit shock? Can it endure a changing regulatory environment? Is its economic moat deep enough to protect against new competition in a fast-paced digital world?
Hope for the future
I hope and believe 2021 will be a better year than 2020. I’m excited about the future, specifically about significant opportunities for alpha and performance differentiation. Why so?
The best companies are the ones creating value for stakeholders, not extracting value from them. While those companies extracting value may have outsized financial performance, its duration is likely finite. Over the past decade, eroding revenue growth has led a growing number of companies to extract value from suppliers, employees, bondholders and customers. However, the best companies — those with a partnership culture across all their stakeholders — tend to possess something scarce: superior financial results that endure and are reflected in their asset prices.
That’s what we mean by allocating capital responsibly, which is our North Star in a highly uncertain world.
Thank you for your partnership. Stay safe and healthy in the new year.
