The unknown unknowns
This time last year we were getting ready for the ‘known unknowns’ - the unpredictable events that we nevertheless knew were on their way. We knew that the Brexit clock would run down at the end of 2020, if not how we would leave. We knew that there would be a Presidential election in November, if not who would be in the White House for the next four years. In the end, of course, the year was dominated by the mother of all ‘unknown unknowns’. The pandemic was a black swan, left field, out of the blue surprise to us all.
This year, you would expect us to be chastened by our lack of preparation 12 months ago, grateful that a terrible year in so many ways turned out to be a lot kinder to investors than perhaps we deserved. If someone had told us in March that many stock markets would end the year well ahead of where they had started, we would have taken it. Human nature being what it is, however, rather than expecting another tale of the unexpected in 2021, investors have pencilled in a year of ‘known knowns’.
The largely unchallenged consensus is that economic recovery, a successful vaccine roll-out and ongoing fiscal and monetary stimulus will see us right.
I hope that is how things turn out. There is a good argument to be made for 2021 being a calmer but once again rewarding year for investors. The coronavirus was the cause of a typical event-driven market stumble, a sharp fall followed by a dramatic V-shaped recovery. The policy response has been massive, the speed and skill of the scientists even more impressive. The economic damage should be much quicker to heal and leave fewer long-term scars than the financial crisis.
Markets have, therefore, entered 2021 in optimistic mood. On both sides of the Atlantic, there is less uncertainty, more of a sense that things can only get better. Last week’s disgraceful scenes in Washington notwithstanding, the small Democratic sweep opens up the possibility of at least two years of decisive government. While there are legitimate concerns about who will pick up the tab, in the short term more government spending is a positive for the stock market. Over here, a thin trade deal is clearly better than no agreement.
But there remain more unknowns than knowns to my mind. And this will make it difficult to manage our investments this year. Relying on the big market narratives that have driven returns in recent years looks risky. It feels like a year in which the micro will matter more than the macro. Stock-picking will determine success or failure more than making the big calls.
For many years - and the pandemic did nothing to change this - investment success has reflected three binary decisions. Being in the right sector - technology, not banks or energy. Picking the right style - growth not value. And being in the right place - if you had a big enough exposure to the US, the rest of your regional allocation didn’t matter much.
I hesitate to call these key questions this year. With the prospect of real GDP growth of 6.5pc or more in 2021 and strong growth again next year, it is easy to argue that this year’s winners will be different from those in 2020. The people who have more to gain from you churning your portfolio than from you doing nothing are, unsurprisingly, making this case.
The parts of the market most responsive to an economic pick-up - resources, autos, energy, travel, chemicals, industrials, banks - have clearly underperformed in recent years.
Some of these sectors, however, face ongoing structural challenges - some, like climate change, pre-date the pandemic; others, the consequences of staying at home, have been accelerated by Covid. Any shift from technology to financials and oil & gas may be fleeting.
Likewise, if you analyse the reasons for the 12-year outperformance of high-growth companies over cheaper value stocks, it is hard to argue that a year of recovery fundamentally changes much. Since the financial crisis there has been a consistent fall in growth expectations and an increase in uncertainty. Inflation and interest rate expectations have collapsed. And a technological revolution has and continues to disrupt all areas of the economy. Yes, the premium that investors have been prepared to pay for the stocks best placed to withstand these trends has increased. But we are right to pay up for tomorrow’s winners. A higher-growth backdrop might narrow the gap for a while but companies that can deliver growth through thick and thin will continue to warrant higher valuations.
As for regional allocations, the US is clearly more expensive than more cyclical markets like Europe and Japan. The UK obviously has a lot of catching up to do now the shadow of Brexit has lifted. Emerging markets stand to benefit from a weaker dollar. But in a recovering world, I wouldn’t bet against Wall Street remaining close to the top of the pack.
So, looking into 2021, I see less benefit to be gained from placing big bets and more from the harder graft of picking the best stocks across sectors, styles and regions. As the digital revolution continues, governments look to build back better after the pandemic and the de-carbonisation of the world gathers pace, there will be winners to spot and losers to avoid. In the meantime, we can only brace ourselves for the unknown unknowns that inevitably lie ahead.