The View from Mount Athos
Investment Newsletter – January 2021
2020 was a wild year. As we all know, the first global pandemic in one hundred years swept across the planet, ravaging societies and accelerating a number of important trends. Pandemics are not unprecedented in history. As Niall Ferguson points out, prior plagues throughout history have caused abrupt and dramatic changes. They cause people to behave in wildly unpredictable ways. Living in a megacity like Los Angeles we are able to observe, firsthand, the social upheaval and abnormal behavior the pandemic has caused. This newsletter is intended to inform our clients and friends of what we think are some of the most important trends in financial markets. The first part of the newsletter describes our current economic and market outlook. While there are clearly areas of excess in the financial markets, we believe we are at the beginning of a new economic cycle with the wind at our back. The second half of the newsletter is devoted to topics we are following closely and are also relevant to the investment process including: the rise of an adversarial China, growth versus value investing styles, and global monetary policy. I hope you enjoy the following analysis and outlook. As always never hesitate to reach out with questions or comments. I look forward to hearing from you.
Simonopetra Monastery, Mount Athos
The Beginning of a New Economic Cycle The Wind at Our Back
As we move into 2021 all of the classic economic and financial indicators show that we are entering a new economic cycle. This past year has seen a wide range of economic conditions across society. While many people have done quite well financially, have no illusion, 2020 was an extremely painful year for many people, especially those most vulnerable to an economic shock. United States GDP contracted nearly 10% during the year and we experienced our first recession in over a decade. One of the most important textbook economic indicators, the yield curve below, inverted in 2019. This always precedes a recession. As we enter 2021 the curve has begun to steepen, just as it always does when a new economic cycle begins. The chart below paints a very encouraging picture as the yield curve begins to steepen, and it still has a long way to go. Historically this has meant there are several years of economic growth to look forward to. This is the wind at our back. In addition, all of the other classic early stage economic indicators are flashing green: small caps, cyclicals, emerging market equities, and commodities. All of these signs point to the beginning of a new economic cycle. Legendary Wall Street strategist Byron Wien of Blackstone has predicted that we will likely see a correction at some point this year before entering the longest expansion in history. Source: Bloomberg
Massive Fiscal Stimulus
The quick and decisive fiscal and monetary response to the recession in 2020 has been effective and unprecedented in size, but it is not over. As the incoming President and new Congress have indicated, further aggressive stimulus to support the economy will be necessary. Research from Rob Arnott, head of Research Affiliates in Newport Beach, suggests that fiscal stimulus has historically flowed through to corporate profits (with a lag) nearly dollar for dollar. This is very encouraging and should provide a further boost to equity investors as corporate profits continue to rebound.
Extremely Accommodative Monetary Policy – Zero Interest Rates
“I’m not even thinking about thinking about raising interest rates.” – Jerome Powell, Chair of the Federal
Reserve In 2012, at the height of the Eurozone debt crisis, ECB President Mario Draghi famously said that he will “do whatever it takes” to prevent a collapse of the Eurozone. This phrase has since become the motto of central bankers around the world. Fast forward to 2020/21, Jerome Powell, chair of the Federal Reserve, has indicated he will keep interest rates at zero and continue asset purchases for as long as it takes to lower unemployment and achieve their inflation target. Such low interest rates boost asset prices by making borrowing cheaper and increasing valuations on riskier assets.
Pent Up Demand
A number of leading indicators of economic growth point to a sharp rebound coming over the next year and beyond. One of my favorite leading indicators is the Korean KOSPI stock index. The KOSPI is one of the best leading indicators of future global trade and economic growth. Exports make up nearly 43% of the Korean economy and the KOSPI has a strong track record of predicting movements in trade and growth. The KOSPI has rallied sharply in recent months and suggests we are at the cusp of a very strong economic rebound as economies begin to reopen. As you can see in the chart on the right, air travel within the United States remains very depressed. While it may take some time for air traffic to return to prior highs this metric is starting from a very low base and has shown encouraging resilience even with the dramatic spike in COVID-19 cases this winter. People around the world are increasingly ready to travel again and this is one of the big pent up forces that has room to recover and the potential to drive strong growth in a number of sectors. Source: Bloomberg
Equities Remain Attractive Relative to Fixed Income
In my last newsletter, back in November (Why High Quality Equities Remain Attractive), I highlighted the recent research by Nobel Prize Economist Robert Shiller which showed the relative attractiveness of equities to fixed income. This remains a very important point. If you were to look simply at valuation metrics for equities as a standalone asset class, you would conclude that they are very expensive. The key point here, however, is that large sophisticated capital allocators don’t make investment decisions in a vacuum. They look across asset classes and weigh the relative attractiveness of each against one each other. The two primary asset classes that compete for capital are fixed income and equities. When fixed income yields next to nothing and has an expected return well below what is required by pension funds and other large institutional investors, the natural course is for capital to flow to equities where the yield and future returns are much higher. This phenomenon has already begun and is behind much of the rise in equity markets across the world. It is likely to continue. This is a very important point and needs to be front and center when making asset allocation decisions. Source: Bloomberg
“We are seeing more participation from clients worldwide in equities,” adding that he was not overly concerned by high valuations in some areas of the financial system. “There is a shortage of great assets and why we are seeing froth in some components of the market. Some companies will grow into their earnings expectations and some will not, that is what we see all the time.” – Larry Fink, billionaire founder of BlackRock
The future will likely be characterized by more volatility than we experienced in the past decade, but that can be a good thing. Volatility is bad for the weaker players in the market and good for the stronger players who can use it to their advantage. As always, when investing in equities it is important to have a sufficient time horizon. If you cannot afford to have your capital tied up for at least three years in the stock market, then it should not be invested in equities in the first place. This is one of the reasons why we focus so much on determining the appropriate asset allocation targets for our clients. The balance between equities, fixed income, and cash allows us to weather volatility from a position of strength.
Growth versus Value?
Within the investment industry, the debate rages on as to what the best investment style is. It is widely reported that value stocks (those with cheap valuations typically defined as low price to book values) have dramatically underperformed growth stocks (those with high price to book values) and, on a relative basis, have underperformed at an all-time high. In my opinion the two styles are not mutually exclusive and, in fact, the best investment approaches combine features of both. Studying the best investment managers and hedge funds of the past 30 years it is clear that the investors who can identify companies with long runways for growth and pay a reasonable price for that growth tend to do the best. Howard Marks of Oaktree Capital sums it up nicely in his most recent memo to investors.
“The two approaches – value and growth – have divided the investment world for the last fifty years. They’ve become not only schools of investing thought, but also labels used to differentiate products, managers and organizations… My belief, especially after some deep reflection over the past year – prompted by my conversations with Andrew – is that the two should never have been viewed as mutually exclusive to begin with.” – Howard Marks, Founder Oaktree Capital
At Athos we continue to utilize a variety of equity investment styles and always seek to partner with great investment managers who have demonstrated skill at exploiting inefficiencies within the market. At the core we continue to favor high quality and dividend growth strategies where we continue to see very reasonable valuations. As we move down the market cap spectrum we favor secular growth companies with open-ended earnings and many years of compounding ahead of them. The technology and healthcare sectors continue to be two of the most fertile hunting grounds for discovering such investments. Cloud computing and biotechnology continue to offer selective opportunities for higher returns, albeit with greater volatility. This is how we structure equity portfolios for clients.
Key Risks Geopolitical Backdrop
The main geopolitical risk that worries me is the rise of a belligerent China. For the past few decades China has enjoyed rapid economic growth while becoming the world’s leading manufacturer. The United States has rightfully supported the development of China as a country and economy. As a result, over three hundred million people have risen out of poverty and in to the middle class, the largest movement in history. However, as things stand today, China and the United States are on a collision course and it is my fear that China has a superior strategy. President Xi Jinping of China has proven to be ruthless, starting in 2015-16 with a brutal crackdown on what the communist party called “corruption”. This campaign allowed Xi to purge the party of his fiercest critics. Since then, Xi has continued to consolidate power and has officially removed term limits, making him de facto ruler for as long as he would like. While very little is known about Xi Jinping across the West he is quite clear about his desire to restore China to global supremacy and make up for “a century of humiliation”. A few highlights from the year:
- Complete lack of transparency and cooperation with the global community on the roots of COVID-19. A full year after its rapid spread, a WHO scientific team has just now been allowed to travel to Wuhan to investigate the origins of the virus.
- Hong Kong’s special status and democratic rights have been completely taken away.
- All Australian journalists expelled from the country.
- Continued aggression in the South China Sea and state-owned oil companies have begun to explore for oil in international waters.
- Confrontations with India along the two countries’ shared border.
- A rapid buildup in military power and projection – China now has more naval ships in the Pacific than the United States does.
China will no doubt continue to be the free world’s biggest adversary, and it is my fear that the response from the West has been too chaotic and uncoordinated. If there is one thing politicians in Washington seem to agree upon, it is a unified response to China. Let us hope that it is not too late.
Irrational Exuberance While I remain constructive on the outlook for equity markets, there are clearly pockets of extreme speculation. One need look no further than bitcoin or the performance of newly public companies (IPOs) to see exuberant and highly speculative behavior. Retail investors increasingly make up a larger share of stock trading volume (20% up from 15% a few years ago). Their impact should not be underestimated. While these areas of speculation are concerning, it remains possible to create portfolios that steer clear of the most blatant signs of excess. Source: Bloomberg
Monetary and Fiscal Policy – an Extension of the Dismal Science
When commentators describe the current state of monetary and fiscal policy they often say we are in uncharted waters. The fact of the matter is that we are always in uncharted territory when it comes to fiscal and monetary. Policy makers do their best to address the current set of circumstances which are always unique. History serves as a guide, but just like the field of economics, monetary and fiscal policy is always a very iterative process. As things stand today monetary and fiscal policy have been pushed to extremes. Interest rates are at zero or even negative across most of the developed world. Fiscal spending by any metric has blown through all prior records. While I believe the fiscal and monetary response has been very good, it remains to be seen what the long term implications of so much stimulus and accommodative policy are. As Jeffery Gundlach of DoubleLine Capital points out, the budget deficit and global money supply have reached all-time highs. As the tectonic plates under the global economy continue to shift, these developments have our utmost attention at Athos Capital. Source: DoubleLine Capital
The Importance of Staying Invested
One of the most vital lessons we can all take from 2020 is the importance of staying invested. The following chart and statistics are ones we keep handy at Athos Capital as we steward our clients’ capital and ride the inevitable periods of volatility that markets often bring. If you missed just the top five trading days of the year your return was -17.9%. Just five days! If you invested on January 1st and looked at your account again on December 31st, you enjoyed a gain of 18.4%. This principle holds even if we look back over longer time periods as well. Examining data over the past 20 years, trading in and out of the stock market has similarly produced detrimental consequences for investors. This is why our upmost attention goes to determining the appropriate asset allocation so that clients can have the fortitude to stay the course and stay invested when volatility strikes. Source: Bloomberg
Stock Market Performance Under Democratic-Controlled Government
In closing, I wanted to highlight one final study. In such a politically charged environment, the question often comes up, “how will the stock market fare if Democrats control the government?” Looking back at history, when Democrats controlled the House, Senate, and White House, the results have historically been positive more often than not. The following data combined with the study on the importance of staying invested should provide comfort to long term investors with the ability to stay the course. Source: Barrons
At Athos Capital, we continue to be cautiously optimistic. All of the classic leading economic indicators suggest we are entering the early stages of a new economic cycle. While we continue to find attractive investment opportunities across asset classes we also continue to vigilantly practice discipline and caution. Huge risks remain, principally in the form of China, pockets of excessive speculation, and the unknowns associated with unprecedented monetary and fiscal policy. Risk evaluation and management is always front and center when we make investment and portfolio management decisions. Our focus continues to be on creating highly specialized investment portfolios for every client while practicing diversification and taking calculated risks where we find asymmetric risk-reward. I hope you have a great start to the year and I look forward to hearing from you.
Henry A. Miketa
Athos Capital Advisors
 The ten components of The Conference Board Leading Economic Index® for the U.S. include: Average weekly hours, manufacturing; Average weekly initial claims for unemployment insurance; Manufacturers’ new orders, consumer goods and materials; ISM® Index of New Orders; Manufacturers’ new orders, nondefense capital goods excluding aircraft orders; Building permits, new private housing units; Stock prices, 500 common stocks; Leading Credit Index™; Interest rate spread, 10-year Treasury bonds less federal funds; Average consumer expectations for business conditions