As we open the curtain on a new year, it always seems to be a favorite pastime to start with predictions of what will happen. Hindsight being 2020 (see what I did there?), nobody could have predicted the events that transpired, and as has been repeatedly stated, we don’t do predictions. Nevertheless, these are three things that bear watching in the coming twelve months:
Value versus Growth
When it comes to the debate between value and growth stocks, Beckett’s classic play Waiting for Godot comes to mind. In the play, the title character never arrives, much in the way value investors have been waiting for their version of Godot. However, in the second half of 2020, value started to close the gap in returns versus growth that had widened to historic levels. The expectation of a much stronger global economy this year, and the recent strong performance of the financial and energy sectors, make for a combination with historically good correlation for value outperformance. This correlation also suggests that international and emerging markets will do better than domestic, given the relative value discount overseas. Lastly, small caps have also greatly outperformed large caps during periods of high government budget deficits.
Cold War 2.0
Notwithstanding the recent political turmoil regarding President Trump, there is little doubt that the President’s dealing with China has fundamentally changed the way they are viewed, both by the United States and the global community. This view goes beyond the trade implications between nations, as China’s initial handling of the COVID crisis has caused many to be skeptical of the Chinese Communist Party’s long-term motives, especially as many countries have not enjoyed the economic rebound that China is seeing. As new trade agreements are signed with Europe, China is no longer seen as a necessary trading partner, and their global standing and reputation have suffered. While it is expected that the Biden administration will be more agreeable to Eurozone trade, the same cannot be said for China. The net result may be somewhat slower economic growth and potentially higher inflation over the long-term, as well as a period in which both Washington and Beijing will compete globally in economic and geopolitical influence.
The Bubble Doesn’t POP
While there have been numerous warnings regarding the “bubble” valuation levels of the market, there usually needs to be a catalyst for the bubble to pop. More often than not, it is not an exogenous event like COVID but something more ordinary in the form of interest rates. While much has been made of the lofty P/E levels of the S&P and NASDAQ being as high as they were during the periods before the 2000 and 2008 crashes, those valuations fail to take into account the real culprit that stopped the party — rising interest rates. More importantly, the absolute level of rates was significantly higher than what we have today. In 1987, the S&P 500 went up roughly 40% January through August as 10-year Treasury yields increased from 7% at the start of the year to 10%. The market finally violently corrected on October 19, although it finished slightly higher on the year. Similarly, in 1999, the NASDAQ increased by 75% as long rates rose almost 2%, and the Fed raised the funds rate three times from 4.75%to 5.5% — we know how that turned out, as well. In both cases, the yields rose to a level that was sufficient to draw money away from risk assets. With the Fed funds rate likely to be pegged near zero until 2023, the party punch bowl still looks appealing.
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