It’s time to go… Back to the drawing board!

As a tumultuous 2020 neared its end, the clouds of uncertainty appeared to be parting. Successful vaccine trials raised hopes that the Covid-19 pandemic would soon be over, the US election result promised a more geopolitical- and market-friendly combination of a Biden presidency and divided government, and rebounding investor confidence fuelled a dramatic rotation into value stocks.

Yet that confidence is already being tested in 2021 as new Covid variants take hold, doubts emerge about the efficacy of vaccinations, and the Democrats’ Senate win stirs fears of an aggressive spending, taxation, and regulatory agenda that’s not favourable to business. The geopolitical, macroeconomic and corporate outlook remains unclear, yet stock markets continue to climb this wall of worry. It’s back to the drawing board!

Investors will remember 2020 with mixed emotions. The Covid-19 pandemic brought with it social and economic upheaval on a scale not witnessed since World War Two. Across the globe, social distancing and travel restrictions upended long-established industries and business models, and placed barriers between families and friends. By the end of the year, more than 80 million cases of the coronavirus had been detected – resulting in almost two million deaths – while countries such as the US and UK reported an ever worsening situation.

And yet, a quick glance at the one-year performance of stock indices shows that 2020 was highly profitable for equity investors. The S&P 500 index of US large cap stocks surged to an all-time high on its final trading day of the year, capping a 16% annual return. Tech stocks generated even greater gains, the most dramatic example being electric-vehicle manufacturer Tesla, which stormed into the S&P 500 index with a market capitalisation seven times greater than that of Ford and General Motors combined.

Such developments bring into question whether markets are driven by geopolitical, economic and corporate realities. As vaccination programs gain momentum across the globe, policymakers face tough decisions regarding supply, speed of roll-out, and efficacy – particularly given the emergence of new Covid variants. Meanwhile, the wage subsidy schemes that shielded many workers from joblessness in 2020 are scheduled to end in 2021, raising fears that unemployment will rise sharply in the sectors worst affected by social distancing and travel restrictions.

For Australia, which fared better than many western nations in controlling the spread of Covid-19, additional challenges lie ahead. Long-running tensions with China spilled into the trade arena in 2020, as the Chinese Communist Party sought to punish Australia for perceived misbehaviours. As a result, Australian exporters are under pressure to find new markets, while policymakers must contend with an increasingly belligerent Beijing. International travel bans place further stresses on an Australian economy tuned to run on high levels of immigration.

Meanwhile, around the world, government debt levels are exploding ever higher, as policymakers seek to counteract the economic effects of the pandemic. A shift in emphasis towards fiscal stimulus - with the Biden administration leading the charge - raises the prospect that long-dormant inflationary pressures may return sooner than expected. Central banks say they remain committed to loose monetary policies, even when such pressures emerge. So for how much longer can it be lower for longer?

In summary, the Markets Summit 2021 theme challenged our faculty to think about the medium-term implications for financial markets of four main ideas:

• stock markets are at all-time highs;
• the path for economic recovery remains uncertain;
• government debt levels are exploding higher; and
• inflationary pressures are building.

Our faculty of 30+ academics, consultants, practitioners and portfolio managers each offer their best high conviction ideas on the drivers of and outlook for the markets (on a three- to five-year view) in the context of the theme, “Back to the drawing board!”.

SUMMARY OF FACULTY PROPOSITIONS

In February 2020, with the S&P 500 index sitting at an all-time high, Markets Summit 2020 explored the idea that portfolio construction practitioners should be alert to the risks and opportunities associated with a volatile, uncertain, complex, and ambiguous – or ‘high VUCA’ – market environment. Tail risks would likely come to the fore. Just days later, the World Health Organization declared the Covid-19 outbreak a pandemic, leading governments to shut down economies and borders, and triggering a crash in international stock indices.

 Markets Summit 2021 is designed to help portfolio construction practitioners and investment advisers go “Back to the drawing board”, to understand the key geopolitical, societal and economic shifts of the past 12 months, and how these will affect the medium-term outlook for financial markets. And then, after reviewing assumptions on the drivers of, and the outlook for, the markets, to consider the implications for portfolio construction.

 Stock markets are at all-time highs, but are likely to go higher still

There are strong expectations among our faculty that, while stock markets are at all-time highs, they are likely to go higher still. ClearBridge Investments strategist Jeff Schulze disputes the widespread view that US equities are in a bubble, and argues that a US recession is highly unlikely. Similarly, Ron Temple, a US equities and multi-asset specialist at Lazard Asset Management, proposes that practitioners should prepare their portfolios for the strongest economic growth in 50 years. Sydney-based investment strategist Jonathan Pain also takes a bullish line on growth, but warns that the stage is set for a “Herculean tug of war” between booming economies and higher yields, raising the risk of violent spikes in market volatility.

 Pain’s warning chimes with one of four key themes which run throughout the Markets Summit 2021 program, namely:

• the ETA of ESG - it arrived in 2020 (late), but it's now here to stay;
• you can no longer afford to ignore geopolitics;
• big government is back, and making more difference than ever; and
• more than ever you must have a clear view on inflation and yields.

 The ETA of ESG - it arrived in 2020 (late), but it's now here to stay

Discussion of environmental, social and governance issues features strongly in this year’s program, reflecting the increased focus on ESG by society more broadly, since the start of the Covid-19 pandemic. From New York, UBS Asset Management president Suni Harford proposes that practitioners must understand the implications of rising appetite for sustainable investing, to thrive in “an ESG world” of transformed capital markets. In the elective Special Interests Forum (SIF) sessions, there are arguments on an array of ESG topics – with a particular focus on the anticipated shift away from fossil fuels, and towards decarbonised economies.

 You can no longer afford to ignore geopolitics

In a world of deglobalisation and heightened tensions between autocracies and democracies, markets will remain highly sensitive to interactions between global policymakers. California-based geopolitical analyst Marko Papic and David Bridges – a Boston-based geopolitical and security adviser to Fidelity Investments, and former senior intelligence service officer with the US Central Intelligence Agency (CIA) – each discuss a key geopolitical risk that investors should be thinking about, as well as the investment implications.

 Big government is here, and making more difference than ever

Western governments were dealt some harsh lessons by the pandemic, raising questions about the state of governance in the world’s largest and oldest democracies. Ngaire Woods, founding dean of the Blavatnik School of Government and professor of global economic governance at Oxford University, proposes that democracies must accept a growing role for China, in setting the global “rules of the game”. As such, Australia, the US, and other allies should focus on building the rules and institutions that they and China need to sustain trade, to ensure international financial stability, and to tackle the global problem of climate change.

 More than ever you must have a clear view on inflation and yields

Markets Summit 2021 showcases a range of views on the outlook for economic growth, and the ramifications for markets and asset classes. Lazard Asset Management’s Ron Temple urges practitioners to prepare portfolios for a return to a high growth environment, driven by pent-up consumer demand, fiscal stimulus and accommodative monetary policy. Meanwhile, fellow New Yorker Jeff Schulze, at ClearBridge Investments, builds on his bullish US equities presentation at Strategies Conference 2020, by outlining why the asset class is poised to go higher still. Our opening keynote, Jonathan Pain, argues that investors are rightly optimistic on the economic outlook, but that rising inflation and yields will drive higher market volatility.

So, it’s deja-VUCA all over again, and it’s back to the drawing board!

 KEY TAKEOUTS

 Closing out the program, a diverse panel of investment practitioners and strategists debate which of the high-conviction propositions they heard during the day resonated most strongly – and which they disagreed with most – to help all delegates think through their key takeouts and the portfolio construction implications of what they have heard at Markets Summit 2021.

 PROPOSITION SUMMARIES

 Our faculty of 30+ academics, consultants, practitioners and portfolio managers each offer their best high conviction ideas on the drivers of and outlook for the markets (on a three- to five-year view) in the context of the theme, “Back to the drawing board!”.

 It’s time to get… Back to the Drawing Board – Part 1

• Graham Rich

As a tumultuous 2020 neared its end, the clouds of uncertainty appeared to be parting. Successful vaccine trials raised hopes that the Covid-19 pandemic would soon be over, the US election result promised a more geopolitical- and market-friendly presidency and government, and rebounding investor confidence fuelled a dramatic rotation into value stocks. Yet that confidence is already being tested in 2021 as new Covid variants take hold, doubts emerge about the efficacy of vaccinations, and the Democrats’ Senate win stirs fears of an aggressive spending, taxation, and regulatory agenda that’s not favourable to business. The geopolitical, macroeconomic and corporate outlook remains unclear, yet stock markets continue to climb this wall of worry. It is time to pause, reflect and go back to the drawing board!

 Be optimistic, but beware – big risks lie ahead

• Jonathan Pain, Author and Publisher, The Pain Report (Sydney)

Global equity markets are celebrating the prospect of a rapid acceleration in economic activity and the remarkable ingenuity of humanity; the light at the end of the tunnel burns brighter by the day. That’s the good news. The bad news is that much stronger economic activity, driven by $22 trillion of monetary and fiscal stimulus, will deliver higher inflation and higher bond yields. It’s back to the drawing board – this herculean tug of war between stronger economic growth and higher bond yields will be the defining battleground of 2021 and will be accompanied by violent and rapid-fire recalibrations of relative valuations.

 China will set the rules of the game; we all must accept that

• Ngaire Woods, PhD, Dean of the Blatvatnik School of Government & Professor of Global Economic Governance, Oxford University (Oxford)

The US, Australia and their allies have long depended on global “rules of the game” (mostly set by the United States) for their major companies and sectors to flourish. In coming years, Australia and the US will have to accept that China will play an ever greater role shaping these rules. China has already become the 3rd largest shareholder of the IMF, a major player in the WTO and WHO, and competed for (and won) the headships of several UN’s agencies. But this should not alarm Australia, the US, and other allies. Instead, they must go back to the drawing board and focus on building the rules and institutions that they and China need to sustain trade, to ensure international financial stability, and for effective action on climate change.

 Ignore geopolitics to the peril of portfolios

• David Bridges, Senior Geopolitical & Security Adviser, Fidelity Investments (Boston)
• Marko Papic, Partner & Chief Strategist, Clocktower Group (Santa Monica)

The days when investors and corporate decision-makers could succeed without much understanding of geopolitics are over. Portfolio construction practitioners must stop relying on news flow for their political analysis, and instead go back to the drawing board and focus systematically on the constraints facing global policymakers, in order to successfully extract the implications for portfolios.

China and the US are geopolitical rivals, that much is clear to all investors in 2021. Geopolitical tensions are likely to increase due to three factors: a Democratic White House is liable to increase, not decrease, tensions; the two great powers do not see eye-to-eye on a slew of geopolitical issues; and, odds of a tragic miscalculation are rising as US policymakers seek to redress China's unfair trade practices. However, linearly extrapolating the pace of tensions from the past decade into the future may be a mistake. While geopolitical tensions will not abate, economic interaction between the two countries will continue, particularly the trade in 19th and 20th century goods. The world is multipolar, which limits the degree to which the US and China can successfully carve out two economic spheres of influence. The Cold War is a poor mental construct - rather, the Great Game of the late 19th century is a better analogy. As such, the world will split into winners - those countries that know how to navigate the emerging multipolarity - and losers - those that fail to understand that the Cold War is not actually back.

 Sustainability is transforming the investment landscape

• Suni Harford, President, UBS Asset Management (New York)

Believe in sustainable investing or not, investors in today’s markets need to understand the impact it’s having on investment returns and portfolio construction. New opportunities abound and may drive macro economics, while access to early stage opportunities is driving investor demand, and markets are already trading on future outcomes. Going back to the drawing board, those that seize the initiative will thrive as the capital markets stand on the cusp of a transformation to an ESG world.

 Don’t be complacent, take advantage of the illiquidity premium

• Rob Mead, MD, Head of Australia & Co-Head Asia-Pacific Portfolio Management, PIMCO (Sydney)

Investors cannot afford to be “lazy” and leave investable capital sitting idle. Expanding the investable universe can help meet the need for positive real returns while maintaining an appropriate level of insurance in portfolios. Going back to the drawing board, it is time to look closely at the illiquidity premium – the one risk premium that offers strong value over the cyclical horizon. A combination of interest rate, credit and illiquidity risks provide diversified fixed income exposures with attractive return potential.

 The world has entered a new investment order

• Ben Powell, CFA, MD & Chief Investment Strategist APAC, BlackRock (Singapore)

The Covid-19 pandemic has accelerated profound shifts in how economies and societies operate and is transforming macroeconomic policy, geopolitics and sustainability. The traditional business cycle playbook does not apply to the pandemic and as this new investment order evolves, investors are returning to the drawing board to identify the key drivers of change. Portfolios must now reflect the new role of developed market bonds given falls in real yields, the realities of an increasingly bipolar US-China world order and the growing investor appetite for sustainable assets.

 Responsible Investing is the future of financial markets

• John Quealy, Chief Investment Officer, Trillium Asset Management (Boston)

After being considered a cottage industry for nearly four decades and now increasingly demanded by investors across developed markets, Responsible Investing (RI) and the application of Environmental, Social and Governance (ESG) factors into the investment process remain misunderstood – and, too often, mischaracterised as style over financial “substance”. Secular, societal and increasingly standardised drivers behind the systemic adoption of RI across all asset classes – along with the ascendancy of shareholder alignment as a growing movement – is clearly evidenced through three issues: 1. the democratisation and development of data in financial markets; 2. ESG integration has been demonstrated to have a positive impact on portfolios; and, 3. the push for passive which misses the point that beyond lack of sovereignty, there is a collective responsibility to align portfolios with client values. It’s time to go back to the drawing board (for many) and construct portfolios with investment strategies designed to advance humankind towards a global sustainable economy, a just society, and a better world.

 A portfolio’s cash allocation is dead

• Chris Rands, Portfolio Manager, Nikko Asset Management (Sydney)

Structural factors are in place which will ensure that the cash rate cannot rise over the medium term. This will result in negligible cash returns over the foreseeable future, with only mild defensive properties. What is the best alternative in the defensive bucket? Going back to the drawing board, a core fixed income exposure consisting of Ausralian government bonds will outperform cash over the long term.

 Relevance & resilience - post-COVID portfolios need G-REITs

• Julian Campbell-Wood, Portfolio Manager, Resolution Capital (Sydney)

During 2020, G-REITs experienced a once in a generation demand shock as many parts of the global economy were effectively shut down or endured severe restrictions on social mobility. Traditional property sectors such as office, discretionary retail and hotels faced significant challenges. But there were many winners - logistics property, data centres, cell towers, self-storage, and single-family rental actually saw demand and return profiles improve through the pandemic. With the vaccine roll-out progressing, G-REITs offer both cyclical and secular investment opportunities. The diversity within the G-REIT universe coupled with the liquidity of listed markets enables nimble investors to efficiently reallocate capital as risk/return outlooks change. Despite significant challenges during Covid, G-REIT earnings were more resilient than broader equities during the pandemic yet experienced some of their worst relative performance in decades. With new building supply and REIT balance sheets in good shape, G-REITs are well positioned as economies reopen and demand returns. Going back to the drawing board, now is the time for G-REITs.

 Scale-as-a-service platforms will reshape the economy

• Josie Bentley, Investment Manager, Baillie Gifford (Edinburgh)

Information technology infrastructure used to be complex, cumbersome and expensive. Today, scale-as-a-service cloud computing platforms allow companies – both large and small – to get their IT infrastructure up and running in minutes. Over the next decade, the growing use of such platforms by start-ups will have profound implications for the global economy, increasing the pace of innovation and disruption.

 Get ready for the strongest growth in 50 years

• Ron Temple, CFA, MD, Head of US Equities & Co-head of Multi-Asset Investing, Lazard Asset Management (New York)

Pent up consumer demand, fiscal stimulus and accommodative monetary policy set the stage for a sharp global recovery. The Biden Administration’s planned COVID relief, infrastructure investment and ambitious climate policies could turbo charge growth. This will bring opportunities for many companies, yet rising discount rates and steepening yield curves pose challenges to investors. Stocks driven by speculative earnings may give way to companies delivering high returns on capital today, while fixed income investors will need to seek alternatives to long duration assets. Following a long period of secular stagnation, it is back to the drawing board in a high growth environment.

 US equities valuations are not in a bubble

• Jeff Schulze, CFA, Director & Investment Strategist, ClearBridge Investments (New York).

The consensus view that US equities are in a bubble are overblown due to several dynamics: index composition; low interest rates; robust forward earnings expectations; and, economic cycle positioning. The biggest obstacle with current market expectations is a double-dip recession which remains a remote possibility based on the positive output of 12 economic indicators that have historically foreshadowed an economic downturn. In fact, economic growth in the US this year is posed to be the best in almost four decades as US consumers and corporations have fortified their balance sheets in the wake of recent lockdowns. Policymakers are suffering from recency bias by mistakenly treating this recovery like the Global Financial Crisis. However, the backdrops between the two could not be more different which sets up a scenario where US equites will continue their ascent higher in the coming year. Go back to the drawing board when it comes to your views on US valuations - because this time IS different.

 High equity valuations are not due to irrational exuberance

• Arvid Streimann, CFA, Head of Macro and Portfolio Manager, Magellan Financial Group (Sydney)

Fiscal stimulus and the vaccine have fuelled an extraordinary rally in equities but ultimately stocks are at record highs because of extraordinarily low market interest rates. This means that for investors, the decision between cash and equities or between sectors hinges on the rates outlook. Even though there are forces keeping rates low, it would be complacent to assume away the risks of higher rates because the inflation outlook is more uncertain than usual at the moment. It would be back to drawing board for investors if inflation pressures structurally rise, because the Federal Reserve put will be kaput and portfolios would need a radical overhaul. Investors should be wary of inflation – but also of being underweight equities.

 It’s back to the drawing board on bonds in a 60/40 portfolio

• Thomas Poullaouec, Head of Multi-Asset Solutions Asia Pacific, T. Rowe Price (Hong Kong)

Investors should reevaluate the role of bonds in a traditional 60/40 balanced portfolio. With today’s very low yields likely to persist, the 60/40 balanced portfolio needs to be “stretched” or redesigned, in order to mitigate the impact of low yields on overall portfolio risk and return. Investors need to make their equity allocation work harder through active management and consider new diversifiers such as long duration bonds or alternatives.

 The resource sector has yet to peak

• Nick Pashias, Co-head of Equities, Antares Capital (Melbourne)

The resource sector is structured around cycle, earnings, capex and returns, but long- and short-term sentiment could be the real drivers. Commodity prices, capex and returns are not yet at peak cycle. De-carbonisation, company management and ESG scrutiny are all emerging themes, diminishing the favoured influence of commodity prices on sector alpha generation. Is this an evolution of value drivers for the resource sector, or are investors just a little late to the drawing board? If long term sentiment begins to turn, then there is significantly more value to be found in the resources sector.

 Private debt is a low risk means to attractive income

• Andrew Lockhart, Managing Partner, Metrics Credit Partners (Sydney)

With the official cash rate near zero, generating income from traditional fixed income investments is challenging. The low-rate environment and prolonged equity bull run pre- Covid drove many investors to overweight growth assets. However, the market volatility of 2020 highlighted the risks of this approach. It’s time to head back to the drawing board to find a more consistent source of income. Private Debt is a lesser-known sub sector of the fixed income market that has delivered attractive yields with high capital stability through market cycles. Debt ranks ahead of equity in a company’s capital structure, resulting in much-needed downside protection. With less volatility than equities, and low correlation to public markets, private debt provides a compelling alternative source of income in a portfolio.

 Equities to rise as we right the wrongs of the post-GFC era

• Crispin Murray, Head of Equities, Pendal Group (Sydney)

Pockets of froth in markets drive the narrative of an equity market top. However, the equity market in aggregate is not as concerning. Equities are underpinned by unprecedented fiscal and monetary policy – aimed at righting previous wrongs - coupled with economic reopening. Earnings growth should result, amid abundant market liquidity, in a zero rate world. Markets remain supported – but divergence could increase within. Covid-accelerated trends include digitalisation, geopolitical tension and the impact of ESG on the cost of capital. These trends are structural and investors waiting for reversion to mean should beware. Going back to the drawing board, portfolio construction along with industry understanding remain the bedrock of investment success.

 Risk must beat reward in post-pandemic supply chains

• Chris Rogers, Supply Chain Analyst - Quantamental Research Group, Panjiva Research (London)

Supply chain decision makers must continue to focus on mitigating risk in 2021, not maximising growth. Logistics disruptions, competition for components and viral mutations overshadow the first half. Further ahead, political risks outbalance opportunities as China flexes its power in Asia, the Biden administration applies what still amounts to an America-first approach, carbon- and digital-taxes abound and new trade deals lead to stronger competition across manufacturing industries.

 Lower carbon will mean more growth

• Chris Iggo, CIO Core Investments, AXA Investment Managers (London)

The energy transition has the potential to be as transformative for the world economy and geopolitical landscape as the digital revolution has been since the 1980s. Shifting from energy derived from fossil fuels to renewables opens up tremendous direct and indirect growth opportunities for investors. There will be increased focus on green bonds and low carbon equities. However, the implications of the energy transition go beyond that. There will be new growth opportunities as many parts of the world economy have the potential to shift from being fossil fuel poor to renewables rich. Standing on the verge of a new decade of transition, it’s time for investors to go back to the drawing board and embrace sustainability, not just in stock selection, risk management or asset allocation, but in every facet of their thinking.

 Secular stagnation is the wrong narrative

• Julian McCormack, Analyst, Platinum Asset Management (Melbourne)

After a decade of falling inflation and interest rates, investors must now go back to the drawing board as we look to a very different world in prospect. The aftermath of the GFC saw a series of discrete factors which crippled growth: fiscal austerity; EU intransigence; Chinese tightening and reform…then a global trade war and a global pandemic! The world has changed. Yet investors appear anchored to a narrative about growth and inflation that will prove supremely unhelpful as the global economy reopens amid vaccine distribution, sees the effective cessation of the “US-versus everyone” trade war and widespread, colossal, redistributive fiscal policy. Those who cling to yesterday’s narrative may forego one of the great trades of recent decades as the world shifts to a “global reopening” narrative and away from that of “secular stagnation”.

 The time is right for non-daily liquid credit strategies

• Peter Robinson, CFA, Head of Investment Strategy - Fixed Income, CIP Asset Management (Sydney)

March 2020 saw extreme intra-month volatility across all markets. Daily liquid funds exacerbated this volatility and failed to provide the liquidity promised to investors. In the subsequent recovery, these same funds are singularly focussed on truly daily liquid investments at the expense of returns. Rather than accepting lower returns for liquidity, investors should go back to the drawing board and re-assess their need for daily liquidity. In this low yield environment, there is a role for non-daily liquid strategies which allow investors to buy when liquid funds are selling, to invest outside of the shrinking universe of highly liquid investments and, ultimately, achieve consistent excess returns.

 Private Equity maximises alpha generating opportunities

• David Leslie, Investment Director, Ellerston Capital (Sydney)

As investors go ‘back to the drawing board’ amidst a changeable market outlook for 2021, private equity is an asset class to access now due to its bias for long duration assets with attractive growth profiles. As structural tailwinds for technology continue to accelerate, there is a dearth of listed options for Australian investors to hold; in contrast, private equity offers exposure to businesses with quality recurring revenues at discounts to listed peers. Often underrepresented in investor portfolios due to concerns around liquidity, private equity investing with a truly hands-on approach allows active investors to maximise their capital growth potential.

 It’s time to get… Back to the Drawing Board – part 2

Our diverse panel of experts debates which of the high-conviction propositions they heard during Markets Summit 2020 resonated most strongly, and which they disagreed with most - and the portfolio construction implications.

• Graham Rich, Dean, Portfolio Construction Forum (Sydney), with experts…
• Anne Anderson, Non-Executive Director (formerly MD, UBS Asset Management Australia) (Sydney)
• Jacob Mitchell, Founder, CIO and Lead Portfolio Manager, Antipodes Partner (Sydney)
• Jonathan Windust, Portfolio Manager & Deputy CIO, Milford Asset Management (Auckland)
• Kate Howitt, Portfolio Manager, Fidelity International (Sydney)
• Tim Farrelly, Principal, farrelly’s Investment Strategy (Sydney)
• Ying Yi Ann Cheng, Portfolio Management Director & Market Technicals Analyst,
• Coolabah Capital Investments (Sydney)