The vaccines are a potential game changer and should allow the world to return to a more normal environment, though the return of widespread social interaction and travel is dependent on a number of variables. We are encouraged by the speed of the vaccine development, demonstrating the incredible power of science and the cutting-edge analytics available to us today. The vaccine, coupled with a new U.S. administration, have led global investors to forecast a robust cyclical recovery in 2021, estimates, though, that rely on additional fiscal spending and pent-up demand needed to close a large output gap.

The Active International Allocation team’s base case for 2021 is more moderate - and we expect it to be a tale of two halves.  In the first half of 2021, we expect a solid economic recovery fueled by the ample liquidity supplied by central banks, a potential new fiscal package from the U.S., as well as some normalization of economic activity as vaccinations are rolled out.  However, the economic comparisons get hard in the 2^nd half. We see a risk to more optimistic forecasts, particularly in the U.S., as political constraints could limit the fiscal spending outlook, while the trail of COVID leaves many industries displaced and with higher debt levels, the pain concentrated in small and medium enterprises that form the backbone of many economies.

Therefore, while we expect 2021 to be a return to business as usual, investors must remember that prior to the pandemic, the global economy was weakening as a result of outsized debt, challenging demographics and de-globalization. While monetary support, fiscal stimulus and an expected new “trade friendly” administration in Washington are all positive factors, many of the structural issues that were holding back the global economy remain. Many industries face a weak demand backdrop, while their indebtedness has increased. We think that while the economic outlook since November 2020 has clearly improved, the optimism in the current global stock markets may be hard to maintain.

So, as the calendar moves into the second half 2021, we see a more challenging fundamental environment, with an important caveat: policy is likely to stay stimulative, while the pain seen by small and medium enterprises is likely to benefit the large, listed corporates. This means that asset prices should continue to be supported by liquidity, where many companies will report significant market share gains that will offset the stalling of main street economic momentum. 

Given this constructive but moderate view, we are maintaining our barbell positioning that has proven successful for the past 18 months. Large value sectors such as financials and energy look cheap on an absolute basis, but we are cautious on the fundamental improvements needed for these businesses to measurably improve. Central banks are likely to keep rates pinned low for years, hurting the profitability of the financial sector; while in oil, it is hard to envision oversupply issues abating without a very large cut in U.S. domestic production, a cut that would need to be coupled with several years of above average growth in global demand.

We are inclined to maintain our current sector and industry positioning, as we think that offers an upside to economic improvement but also some ballast, as many of the companies we hold have strong balance sheets, sizeable competitive advantages and high recurring revenues/strong cash generation.

Some Thoughts on Inflation and Debt

One topic always on our minds is the battle between inflation and deflation.  Since Paul Volcker squashed it in the 1980s, inflation has essentially been non-existent in most of the world over the last decade. Look at Japan and Europe, where despite trillions of dollars of asset purchases, both are currently faced with deflation.  Several structural factors have kept inflation tame, most notably China’s entrance into the world economy, an expansion of labor markets from offshoring, the emergence of a just-in-time global supply chain and productivity increases via technological innovation. However, the absence of inflation is also a direct result of a world economy hobbled by the pernicious effects of historically high debt levels.

While central banks have recently unleashed tremendous amounts of stimulus, the end of the disinflation/deflation trend is likely to be marked by more draconian solutions to high debt levels. Lower rates and abundant liquidity – aka cheap money - has allowed the world economy to continue to service their high debt levels. It also serves as a catalyst for new debt, which brings with it a short period of GDP acceleration. We have witnessed this the past decade and firmly believe it is a model that is no longer viable, as the mammoth debt piled up needs ever-increasing new debt to drive ever-less incremental growth. A vicious circle indeed.

It is our view that this debt problem must be solved by severe measures including default and/or significant restructuring - otherwise large economic actors will remain hemmed in by the constant struggle of servicing their debt. This was the exact backdrop the global economy faced in the pre-COVID years, a trend that is now reasserting itself, even as a vaccine should allow critical segments of the economy to reemerge in 2021-22.  This is not to say that the world economy is doomed and that we will not get a cyclical rebound in the upcoming year. We do expect a rebound. It is only that we think the prior trends will reemerge and return us to a subpar growth environment in the medium term. While some think that the much lauded MMT (Monetary + Fiscal stimulus) will be a game changer and lead to increasing GDP trends, even if we get such policies the experience of Japan in the last several decades argues against such an outcome. MMT-like policies have been used widely in Japan since the 1990s, resulting in only brief periods of acceleration while the economy’s trend growth rate has been stubbornly low.  We think that Japan’s experience should be the base case for our forecasts, until the global debt overhang is directly addressed.

Portfolio Opportunities

So where do we find equity opportunities? One theme we like revolves around the metals and mining space.  Our portfolios are currently overweight copper and gold mining stocks, where we see a favorable supply and demand outlook for both of these important commodities.

• Demand for copper is expected to rise as the world “goes green,” whereas supply growth has been declining for years. Copper miners have been discovering fewer new veins, launching fewer high return projects, and investing less in capital expenditures. Inventories are low. Over the next five years, rising demand for solar and wind power and electrical vehicles could increase annual demand for copper by ten percent. 
• We are also quite bullish on gold, which should benefit from lower real interest rates and near-term global fiscal spending. Our research shows that over the past one hundred years, the price of gold, adjusted for inflation, has risen by an average of just 1.1 percent a year, compared to 6.5 percent for U.S. stocks. Even the 10-year U.S. Treasury bond has outperformed gold. But, gold has done best when interest rates fall below the rate of inflation, and since 2006, gold has slavishly followed the fluctuations of real yields and the U.S. dollar. As the inflation-adjusted return on bonds turns negative, we expect investors to own gold as a store of value, even if it yields nothing.

For a more detail discussion on commodities please listen to audio produce by Jitania Kandhari, Co-Manager of the Active International Allocation – “The Case for Commodities This Decade.”

Summary

2020 brought many challenges to the world.  Throughout the year we have maintained our investment discipline and look to take advantage of the most promising secular and cyclical opportunities. We believe our flexible and repeatable investment process is well suited as the investment landscape moves into the post-pandemic period.  Periods of transition require a longer-term perspective and an ability to tune out shorter-term noise. As always, we remain vigilant for changes to our fundamental outlook and investment thesis, and may take actions to change the makeup of the portfolio as our reading of the economic and market conditions evolves.

We wish you, your teams and families a happy and healthy holiday season and a prosperous 2021!

RISK CONSIDERATIONS
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio.  Please be aware that this portfolio may be subject to certain additional risks. In general, equities securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, market and liquidity risks. The risks of investing in emerging market countries are greater than the risks generally associated with investments in foreign developed countries. Stocks of small-capitalization companies entail special risks, such as limited product lines, markets, and financial resources, and greater market volatility than securities of larger, more-established companies. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the Portfolio’s performance. Illiquid securities may be more difficult to sell and value than public traded securities (liquidity risk). Non-diversified portfolios often invest in a more limited number of issuers. As such, changes in the financial condition or market value of a single issuer may cause greater volatility.