As we turn the page over for what has been one of the most challenging years for the human population as a whole, we want to take the opportunity to sincerely thank all of our clients for the trust and partnership they have bestowed upon us over the years. We mourn with all of you the human and financial hardship that this pandemic has caused many individuals and families around the world, and we welcome and hope for a quick transition to post-COVID life.
Although the battle against COVID-19 is far from over, and we are currently facing an escalation of restrictions worldwide as a consequence of the strong rise in cases and hospitalizations, the end of the storm is now more visible. National health associations have approved more than three vaccines, more than 25 million vaccines have been administered in 42 countries as of January 8, developed country governments have unanimously embraced fiscal stimulus against the crisis, and economic activity has rebounded from the Q2 trough. Although the damage of the pandemic will linger for many months in the future as measured by employment loss, GDP decreases, and foregone investment, human and therefore economic activity will normalize, and it is clear stock markets have reflected this gradual stabilization.
Before we embark on our customary technical analysis of the economic and financial pulse of the main world regions, we see this market commentary as an opportune time to share some of the lessons our team has learned throughout the past 9 months. The following lessons have shaped most of our investment views and therefore explain our current operational framework for analyzing future macro events:
- Uncertain times require a deeper review of fundamentals
- Uncertain times require bold calls
- Flexibility is essential for survival
- Extreme sentiment paradoxically signals instability
- Shocks accelerate changes
There are many ancillary insights that stem from the first lesson yet the central message here is that unstable and uncertain times awaken the need to reevaluate fundamental ideas and theses. 2020 invited us to review our default asset allocations. We were called to revisit the main mechanisms of asset valuations, to study and question the reasoning behind our investment style selections and to reconsider our premises of asset class correlations. This review solidified some key investment principals, including the importance of interest rates for asset valuations, the pertinence of relative asset class attractiveness and the need for robust portfolios with very diverse risk exposures.
The lesson that naturally followed the detailed review of fundamentals was the need to re-establish firm theses with contingency plans in case of unexpected events. At the trough of the market correction in mid-March, uncertainty about the virus was at its height and health institutions and government entities were forced to make difficult decisions with very limited information. Senior government officials around the world had to choose between limiting social activity, thereby risking high economic costs, or risking the potential of high mortality rates due to clogged hospital infrastructures. Our action decision tree was to decide whether to maintain risk exposure in equities and, if so, what areas to avoid or overweight. In hindsight, the decision appears relatively simple, as the market had taken an unprecedented quick nosedive and long-term absolute and relative valuations for equities looked attractive. The reality at that moment, however, was filled with uncertainty about the virus’ biological profile accompanied by lack of clarity about the magnitude of the human and economic damage at stake. IWA decided to maintain the risk allocation to equities, a call that was later reinforced with the publication of massive monetary and fiscal stimulus plans from most of the G20 and many emerging economies´ central banks and governments. This risk-neutral call, however, was contingent upon a careful analysis of unfolding events and on using China as a guide for potential coexistence with the virus.
Our plan led naturally to the third lesson, which was the need to be flexible in our assumptions and therefore our positioning. We had established our clear long-term view yet it required being flexible and ready for quick repositioning. Our preference for active management is an extension of our adopted desire for flexibility in our investment decisions.
Human psychology shows up frequently with very clear lessons in the investment profession, reminding investors to question herd mentality and extremism. The notion that extreme sentiment signals instability was not new to us in 2020. March pessimism was too strong and, although the multiple unknowns from the pandemic made it appear normal, blindly adopting that pessimism would have cost investors the strong rally that began immediately thereafter. Oddly enough, we now stand at the other side of the balance where the equity markets have strongly disregarded short-term potential disruptions and concentrated on the eventual normalization of the economy.
Lesson number five applies to many situations. Momentum is as true in the natural world as it is in human psychology and therefore a verified factor in the financial arena. Changes are regularly gradual and it is hard to reverse the paths of objects, tendencies, and preferences. What was very evident over the past 9 months, however, is that whenever there is a shock and activity is stopped more abruptly, agents have the opportunity to implement meaningful changes and therefore accelerate previously desired ideas. This reality was visible throughout multiple industries including the vast demand and adoption of remote work infrastructure, renewable energy projects, and the real estate repositioning toward e-commerce, data storage and communications. At IWA, this shock allowed us to solidify our view that government bonds will not fulfill the same indirect hedging capabilities to equities as they had served in the recent past. We therefore had to look for and implement new strategies to provide structural stability to our portfolios.
The World Bank just published a projected activity decline of 3.6% year over year for the U.S. economy from 2019 to 2020. We will witness the inauguration of the Biden Administration and the beginnings of a Democrat controlled Congress, the latter perhaps instrumental to passage of much of the Biden – Harris agenda. After the implementation of the CARES Act at the end of March, where the U.S. economy saw an infusion of a $2.2 Trillion stimulus bill, Congress agreed to a further $900 Billion bill in December. As the Democrat Congress gets underway in early 2021, it is likely the U.S. economy will witness a further extension of the stimulus packages with a potential partial implementation of the proposed HEROES act. The World Bank projects a 3.5% acceleration in the U.S. economy for 2021, a number that was adjusted downward given the reality of the COVID surge we witnessed in the closing months of 2020.
U.S. equity markets have enjoyed a strong rally from the meltdown of 33.6% in the S&P 500 Index between February 17 and March 23, which closed 2020 with an 18% positive total return. The U.S. indices enjoyed better performance relative to other developed markets because of their higher allocation to the tech sector, which showed earnings resilience amid the pandemic, and because of less stringent activity restrictions from government entities.
The strong fiscal relief has reduced the probability of strong corporate and household defaults and consequently the likelihood of prolonged weak employment numbers. Equity markets and corporate bonds have reflected this unprecedented support. Investment Grade spreads to U.S. government bonds are back to pre-COVID 19 levels meaning there is not much space for spread compression. High Yield bond prices also indicate a steep decline in default rates in the next 12 months. Valuations are not attractive in any particular liquid market, but this will not be enough to escalate outflows from risk-on assets. Valuations can stay rich for a long time and, with prospects for continued economic activity improvement, exposure to risk-on assets, particularly equities, seems more attractive than exposure to government bonds with their historically low yield levels accompanied by the risk of higher inflation.
Europe and Japan
Against the backdrop of this historic recession, the Euro Area´s fiscal response has been groundbreaking. Never before had the EU granted joint fiscal stimulus to its member nations. In a historic speech on May 24, European Commission president Ursula von der Leyen announced a 750 Billion Euro package made up of grants and loans to be used by the 27 member nations. With over 580 thousand deaths since the first recorded death on February 15, 2020, Europe has suffered tremendously with the pandemic. The Euro Area is expected to have had a staggering 7.4% GDP contraction in 2020, as many member countries were forced to implement stringent activity restrictions beginning in early March. The EU is now grappling with soaring new cases from mutation B117 which is believed to be much more contagious than the previous strain. Europe, which also had to live with the drama of the Brexit negotiations in 2020, will face a very difficult Q1 2021 as they implement a vaccination campaign which got off to a sluggish start compared to the U.S. and Britain. European equity indices have nonetheless looked beyond the short-term pain, and the MSCI European index posted 5.9% return for 2020 in U.S. Dollars. The Euro appreciated following March as markets learned about the extent of the U.S. fiscal package and as rate differentials between U.S. bonds and European bonds compressed meaningfully.
Japan enjoyed a more muted human toll from early and effective lockdowns and tracing methods for COVID 19. Saga´s cabinet recently endorsed an extension of the relief package rolled out in April, bringing the combined total value of COVID-related stimulus to $3 Trillion. The MSCI Japan index returned 15.4% for 2020 in USD.
China and Emerging Markets
China will be one of the very few countries with a positive GDP for 2020. The World Bank projects the Chinese economy grew by 2%, its slowest pace since 1976. Apart from very stringent activity restrictions in the first four months of 2020, and very effective tech driven tracing mechanisms to target and limit surges of the virus, China combated the pandemic like most developed nations with sharp fiscal and monetary infusions. Government debt grew at almost twice the pace in 2020 than it did between 2009-2018. The Chinese manufacturing sector took a nosedive in February of 2020, but after March enjoyed a gradual pick up every month until posting a decade high PMI Caixin Manufacturing index number of 54.9 in November. Although the credit and fiscal stimulus momentum has resided, the Communist Party of China is commemorating its 100th anniversary in July of 2021, and it is therefore unlikely it will allow for economic activity to weaken. Growth is expected to pick up 7.2% in 2021 and this stimulus driven acceleration will have meaningful impact for commodity oriented emerging economies. Emerging economies have unfortunately been the most profound victims of this pandemic. Across the board, economies reliant on commodity exports, tourism and informal service employment saw the worst side of pandemic restrictions. Many nations had to respond with very rigorous activity limitation policies since their subpar health infrastructures were overwhelmed quickly. Latin America suffered tremendous health and economic distress. The UN commission for Latin America and the Caribbean has calculated that around 45 million more people were forced into poverty in 2020. Latin American nations also had limited ammunition to combat the economic damage in their populations. While the U.S. and Europe were able to invest around 30-40% of their GDP in fiscal packages, Latin American nations spent less than 10% on average. Although the IMF and the World Bank offered generous debt provisions to challenge the crisis, the region will be significantly underinvested to combat the profound economic repercussions that will linger from this crisis. Financial markets have reflected this economic agony. The Brazilian Real depreciated more than 30% relative to the USD since the beginning of 2020. The Mexican Peso, Chilean Peso, Colombian Peso and Peruvian Sol all suffered from strong outflows and dovish monetary interest rate moves in the first four months of 2020.
Although it sounds bizarre, the biggest enemy for assets at the current economic juncture is a quick jump in real long-term interest rates. The biological warfare from COVID 19 has generated a united front of robust fiscal stimulus packages and energetic central bank asset purchases, flooding the world with liquidity. Although some industries suffered tremendous earning losses, others such as technology software were undoubtedly winners. Anti-cyclical welfare support will limit economic pain and investable risk-on assets will likely maintain their high valuations as activity improves and stabilizes. The real silent nemesis for this odd financial stability is that of higher interest rates. If inflation escalates at a much faster and abrupt pace than expected, central banks will have to step on the brakes, compromising high asset valuations, debt sustainability and interest rate sensitive industries.
Our mid-year review discussed our neutral allocation to equity risk relative to fixed income. We discussed our expectations of higher realized volatility and potentially wider sell-offs amid a foreseeable upward path for world equities in the years ahead. We continue to believe equities have stronger fundamentals than fixed income assets, and we have moved to a slight overweight to equities in our portfolios. We remain highly invested in active strategies that overweight companies with high quality business fundamentals. Our regional equity allocation has increased exposure to ex-U.S. equities, deriving from a fundamental view of the end of the bullish dollar cycle, and the wider valuation gap between U.S. equities and ex-U.S. equities. With the gradual improvement of the global economy, cyclical industries, which have lagged tech and growth-oriented industries, are likely to post positive price dynamics amid a stronger earnings outlook. IWA´s allocation to small Cap U.S. equities, ex-U.S. developed market equities and emerging economies´ equities will possibly benefit from the normalization of economic activity, as their allocation to cyclical industries is higher than that seen in the S&P 500 and Nasdaq indices.
Our positioning within fixed income has not changed meaningfully. We are overweight high-grade USD bonds, which continue to have strong fundamental support from the FED´s asset purchase programs. We also continue to hold lower duration bonds relative to benchmark levels, as risks of higher inflation expectations have increased. When suitable, portfolios will hold a higher allocation to cash to allow for opportunistic purchases amid equity sell-offs. Where possible and appropriate, we will continue to increase portfolio exposure to some indirect equity volatility hedges. Gold, managed futures and higher exposure to private offerings are some of the recipes. We continue to fight low-yielding public market bonds by buying private credit with similar credit risk and, if acceptable within portfolio parameters, replacing credit spread risk with core real asset strategies.
JP Villamarin, CFA, CAIA
Senior Investment Analyst at Intercontinental Wealth Advisors
*Markets are constantly changing. Market Update information is a snapshot in time intended for information purposes only. Intercontinental Wealth Advisors, LLC offers various strategies and different strategies may have different market outlooks.
 Data collected by Bloomberg
 Performance numbers obtained from Bloomberg Terminal
 World Health Organization numbers
 As published by Nikkei Asia
 World Bank 2021 Outlook
 Data from United Nations Economic Commission for Latin America and the Caribbean
Chart 1. Reference Indices 1Y Performance as of January 8th 2021