In January of last year, my quarterly letter was a retrospective on the decade of the 2010s, a successful bull run period in which global equity markets rose 132%. We also reflected on principles and themes that contributed to positive results for Pitcairn clients during those 10 years. Now 12 months later, I am inspired to offer a retrospective and a reflection on themes that proved especially relevant in 2020. Though the calendar says just one year has passed, it feels like we have endured an entire decade!
Einstein once said of Gandhi that generations to come would scarcely believe such a man walked this Earth. I think future generations may scarcely believe the scale of events in 2020. From the pandemic tragedy to widespread social unrest and deep political divisions to the surprising resilience of capital markets, 2020 was unprecedented in so many ways. For the first time, governments across the globe intentionally shut down their economies to protect the health of their citizens. US GDP fell 32.9% and 22 million jobs disappeared in one quarter. Yet, the Nasdaq rose 43%, the IPO market was incredibly strong, many people became first-time stock investors, a technology bubble emerged, and bitcoin surged.
A year that brought so many extraordinary events is worth a step back to see what we can learn. Five lessons stand out to me.
1. Fear is still the enemy of successful investors.
Every time a crisis introduces fear into the markets, some pundits say that this time is different and we can no longer rely on principles and strategies that worked in the past. They are partly right. Every crisis is indeed different. However, reactions to those disruptions follow a pattern. Time and time again, capital market responses have been predictably similar. First, there is panic, then capitulation, and inevitably recovery.
People who are steadfast in following their investment policies can stand back from the vortex of emotion and fear. The result: their portfolios perform better in the long run. The past year has truly underscored this reality. On March 23, 2020, almost no one thought it was time to go long in stocks. Most were asking how far markets would fall. Yet, those who stayed in stocks have enjoyed a remarkable recovery. The Russell 3000 Index, a measure of the US equity market, is up 70.4% from its low, delivering a return of 20.9% for the calendar year.
2. Technology Brings the World Closer
The pandemic irrefutably demonstrated the interconnectedness of our world. No person and no country was immune to the effects of the virus. We all shared the same worries about the well-being of our loved ones and the same practical challenges – like where to get food, hand sanitizer, and toilet paper.
Over the last four years, the US, and to some extent other countries, reassessed the fairness of existing international trade structures. We renegotiated NAFTA and experienced a sharp rise in trade tension with China. The cumulative effect was a dampening of global trade. There has been much debate about the appropriateness of the reassessment, but I view the political foray to be a short-term trend, while greater interconnectedness, driven by technology and commerce, remains the inevitable longer-term outcome. People all over the world want similar things – to take care of their families, live a better life, and do well by their children.
Immigration remains a hot button issue and while every country needs a set of fair immigration standards that work for all parties, it’s important to remember that immigration can meaningfully support economic growth. The race for a COVID-19 vaccine benefited significantly from the contributions of immigrants. BioNtech, which developed Pfizer’s highly effective COVID-19 vaccine, was founded and run by a husband and wife whose parents immigrated to Germany from Turkey. For the US, it’s pretty clear that skilled and talented immigrants are essential to drive future GDP.
Although globalization invokes sensitive issues, we shouldn’t let debates about international trade practices and immigration obscure the positive outcomes for global capitalism that these opportunities present.
Going global will likely be profitable for investors as well. World markets are coming off 10 years in which US stocks delivered the highest returns. A reversal in that trend appears likely as the dollar weakens in response to US monetary policy and increased government spending. We maintain our commitment to globally diverse investment portfolios, with exposure to emerging markets and non-US developed markets.
I recently heard a successful investor say that technology will unleash the talent and ingenuity of all humanity in ways that is only just beginning. It would be hard to find a more optimistic and bullish pronouncement on the potential of global investing.
3. Fed Policy Matters Because the Price of Money Matters
Clients have sometimes chided me for how frequently I comment on Federal Reserve activity. I do so because interest rates, a.k.a. the price of money, is the most important statistic when assessing financial markets. This past year confirmed that investment managers must be students of global central bank policy. While there are differing opinions about the long-term economic impact of the Fed’s extreme monetary policies, the “shock and awe” with which the Fed (and other central banks) pushed monetary stimulus into the economy in March precipitated a swift rebound from a record decline in US GDP, which in turn enabled the stock market’s robust rally.
I must confess to being annoyed when some credit the entirety of the 12-year bull market to the Fed’s easy money policy. True, Fed policy indirectly benefited the business climate and kept the cost of capital low, but record corporate earnings were due to much more than just Fed actions. The Fed (and other central banks) does, however, have a direct effect on the multiples equity investors pay for those earnings. Right now, price-to-earnings multiples are high, in large part because interest rates are so low. Current low interest rates are the bane of savers, a boon to investors, and the key to smooth capital markets in 2021.
As investors, we must now consider how long the Fed can or will maintain this exceptionally accommodative monetary policy. Inflation expectations are integral to that analysis. The Fed’s balance sheet grew from $3.9 trillion to $7.3 trillion over the course of 2020 (See Chart A), equal to 33% of US GDP. However, this ratio is similar to other major countries – China at 35% and Europe at 55% – and much lower than Japan at 126%. A large balance sheet is not itself a guarantee of inflation.
Growth in federal spending may also drive inflation expectations. Former Fed Chair and current Treasury secretary Janet Yellen believes strongly in fiscal stimulus to support employment, giving us reason to expect increased spending. The $900 billion second stimulus package, which passed late in 2020, is being rapidly deployed, and Democrats have already proposed substantial additional stimulus. It remains to be seen how quickly the recent stimulus and any new stimulus translate into GDP growth. After 5-6% GDP growth in the fourth quarter of 2020, we now anticipate 1% growth in the first quarter and somewhere between 5 and 7% growth for the balance of 2021.
Fed support has been vital from the outset of the pandemic in 2020 and remains essential for the continuation of our economic health and the bull market. My preoccupation with the Fed will continue as we watch for signs of inflation that might alter the Fed’s course. The importance of this experiment of supporting the US markets through central bank policy has never been more evident.
4. Politics Should Not Drive Portfolio Positioning
The potential downside of letting politics overly influence portfolio positioning was abundantly clear in 2020. Many people were convinced stocks would crash if Biden were elected or Democrats gained control of both Congress and the presidency. Consider the missed gains for investors who let that certainty guide their actions.
I firmly believe we all should lean in and work through the political system to make our voices heard. However, we should never let politics scare us out of the market or sway us from our long-term plan. Markets are discounting mechanisms that look to the future. I did not think markets would tumble regardless of who won the November election; in fact, there was a strong rally toward the end of the year and into January despite an outcome many had feared.
5. Optimism is a Precious Commodity
Optimism was hard to come by in the middle of 2020. Gripped by pandemic fears, we scoffed at any possibility there would be a vaccine in January 2021. Now we have two highly effective vaccines, 4% of the US population has already been vaccinated, and pharmaceutical companies predict 200 million Americans will be vaccinated by July.
Optimism with diligence is the trait of a good investment manager. If I buy a stock at $20, it could fall to zero. But that stock could also rise to $500 or $5000. We should not always fixate solely on the downside risk and lose sight of the upside potential. Just look at the past year – how many companies innovated, pivoted, and produced wholly new technologies to cope with a global threat. That alone should fill us with optimism.
The rapid development of COVID-19 vaccines is just one example of what is happening in all kinds of endeavors. Scientists used new technology to expedite a process that previously took four years or more and produced multiple effective vaccines in six to eight months. That kind of disruptive innovation is happening and will continue happening across business models and industry sectors. Optimism helps us look beyond current challenges to appreciate the power of this truly bullish trend.
Pitcairn Outlook and Positioning
As we begin 2021, interest rates remain low, inflation is nonexistent, and the Fed has given every indication it will keep rates low. Democrats are pushing to get money into the hands of Americans, while also proposing significant infrastructure spending. The economy is in the early stage of a new cycle and likely to benefit from substantial pent-up demand. Consumers are eager to travel, dine at restaurants, and shop as soon as they are able. And unlike 2008, they have the balance sheets to do it – US household net worth rose $10 trillion in 2020.
See Chart B to perceive how vaccinations are occurring at a faster rate in the US than they are globally, potentially putting the US in a stronger position to reopen its economy more quickly than the rest of the world.
Following impressive stock market gains in 2019 and 2020, much of the positive news in our current environment is already reflected in stock prices. Still, absent a major exogenous shock, it is hard to see the 2021 backdrop for risk assets as anything other than supportive.
With that said, a near term pullback in US stocks would not be surprising. After rising 70% from the low on March 23, 2020, US stocks may need to rest from the speculation of recent months. We don’t know for sure what will trigger such a pause, but risks include negative pandemic news, a slowing economy in the first half of the year, and the possibility that long-term interest rates may rise.
The biggest threat to stocks is an unforeseen inflationary shock that compels the Fed to tighten monetary policy and reverse its well-telegraphed 2021 course. Super inflation does not appear likely in the near term given how tremendously disinflationary the pandemic and resulting lockdowns have been. However, one day the Fed will determine inflation is too high and take steps to rein it in. Such Fed action has ended bull markets and asset bubbles in the past. To be clear, we don’t see that happening this year and possibly not for two or three years, but it will happen and stock prices will suffer, at least in the short term, when it does.
Regarding Pitcairn’s positioning, we stand by our evidence based view that globally allocated, diverse portfolios provide the best potential to achieve long-term investment success. We continue to see attractive valuations and opportunities around the world. We have rebalanced portfolios to their policy targets and trimmed positions where valuations have gotten too high. As discussed above, we are keeping portfolios exposed to international and emerging market equities, which have underperformed and now appear likely to benefit from a prolonged period of US dollar weakness.
The important message is that we are not making any significant changes to the asset allocation that has served our clients so well over the past years and are letting our managers, who we believe are the best in the world, continue to take advantage of these extraordinary circumstances to add value as they did in 2019 and 2020. As always, we remain true to our discipline because a good investment policy will guide us through any fear or uncertainty.