November 23, 2020 - Monthly Update

Dear all,

Even though this is 2020, with all its issues, we still have a lot to be thankful for. Thanksgiving like we’ve never had before was on last Thursday and with that, the Holiday season 2020 has started. This year might feel different than what we are used to, but it should be celebrated and enjoyed never the less.

Investor confidence grew stronger since the election and the announcement of the effectiveness of the vaccines coming up for approval for usage against the corona virus. Rotation in “preferred” equity class that we were describing and waiting for, started with that new-found confidence. Money started moving from tech-based growth companies to more traditional stocks and value. Cyclical stocks started moving up signaling that we are getting out of a recession.

Yes, Covid-19 remains a major health and economic challenge, but after months of pandemic life, some lessons have been learned. Instead of complete shutdowns, there are targeted lockdowns which are at least in some places preplanned and followed. A Thanksgiving spike in cases is possible, but there is evidence that a trained reaction may kick-in and keep most of the economy moving.

Looking into issues that will be driving investors decisions in 2021, we find enough positives to recommend continued overweight in equities over other assets. Portfolios should likely still be investing in tech growth while balancing it with diversification into value and smaller stocks. With the US dollar further weakening compared to other major currencies, investors should start adding a little to their emerging markets positions. The key with these allocations will be to stay selective and careful as much as possible, while making sure that each portfolio is focused on performing its function in the overall plan. Here are some reasons why we are staying positive about our near future:

  1. On the vaccine front, the news remains very good. Two vaccines are here and have applied for emergency use approvals. Seven additional treatments are moving fast towards the same point in the process. We should be thinking in terms of numbers and quality – the more qualified vaccines that come to the market, the more can be distributed and the staling parts of the economy can reopen and start producing.
  2. The monetary policy remains favorable by providing plenty of liquidity and favoring risky assets. The US Fed’s unprecedented moves in fixed income markets, on top of the aggressive rate policy, have proved effective so far. There is no reason to doubt that the Fed and its counterparts in other powerful economies will still continue to be supportive of the economy.
  3. The chance for the additional fiscal-policy stimulus is high. It does not look like the second package coming from Congress will be as big as the Fed and the markets were hoping for, but it should provide the necessary, targeted support for the industries and workers that need it the most. Additionally, there is still possibility that some long-term infrastructure plans might be coming as the issue stands high on both parties’ lists, and as it could give a boost to both employment and GDP growth.
  4. As we move further away from the elections, the composition of the new Congress and the new administration becomes clearer. The tight balance in both houses and experienced administrators are preferred by the markets, since the level of predictability will be higher and no extreme policy changes would be expected.
  5. Lastly, it really does seem that our hopes for a V – shaped recovery became the reality. We were in a recession and now we are in a recovery. Economists will only later in 2021 be able to confirm this with data, but as we are moving further in the cycle, we push our next expected downturn further away. Remember that bull markets tend to finish the year strong and December tends to be one of the strongest months historically (up 73% of the time since 1928).

Of course, any issues with vaccine approvals or distribution could be hurtful to the economic recovery and the market performance. Staling with additional fiscal support by the US Congress would also increase the volatility. Some ratios are showing that parts of equity markets could be overvalued if measuring total outstanding value of those assets against the US GDP. Inflation could come from an unexpected source if the demand from consumers recovers before the supply chains get reestablished. However, over the next few years, the acceleration of the changes in the industries and the way we live and work, will matter more. As dust settles, we may realize that we are a decade or two ahead with the acceptance of technological advancements and their implementation. Recognizing who are the potential winners, and who are (more importantly) the losers in this process is second only to overall asset allocation for investors. As we commented before, active management focused on specific goals will be important in the next few years.

Three issues stand alone in our clients’ minds as possible problems to their investment plans. As we were going through our client meetings during the nine months of the health and economic crisis, I noticed in reviewing meeting notes that these three issues still rank high on the list of your worries and fears. The new geopolitical/economic balance, debt of the US Government, and the stubbornly low interest rates are and should be on our list of issues as investors. They are all parts of a super-cycle we are going through now. I had long discussions with some of you about these, so please don’t mind if some of this gets repeated.

To describe our view of our world trying to reach a new balance, I am including a part of my writings from our 2017 in Rear View letter that focused on this issue. Attached to this letter you will find a report by Wells Fargo Investment Institute titled “Paying America’s Bills”, a well-researched and written paper with retail investor in mind, dealing with the US debt. Lastly, I am including my short comments on interest rates.

Our World – (from our With 2017 in Rear View letter – January 2018)

I talked about a new world power system for a long time now. The phase that the US started after the WWII and won in the two-power system (because of its pursuit and enforcement of the world order based on rules, democracy, protection of rights and property, open communication and trade – created mostly by us and for our long-term benefit) transitioned into a super-power system. For a long time, our country created and enforced the rules others had to follow. Single super-power system opened the possibility for globalization. This process, as criticized as it is by some from both developed and developing world, made our country and our investors the biggest beneficiary of its spread. Arguably, it also did a lot to improve the situation of many people around the world and bring billions into middle-class pools that the marketing machine can now target and turn into consumers. It was only natural that with better communication, education and increased wealth, some of the other actors on the world scene start emerging as regional (and world) powers determined to either revive their historically-based claim to the power status, or realize their potential and set themselves on the course towards becoming a brand-new power. Most of the creators of our foreign policy, both academic and practical, correctly predicted this process and steered US into the lane of gradual, planned adjustment and pull back. There is nothing wrong in accepting that China, India, Russia, Turkey, Iran and a combination of South American states are becoming important world actors like US and Europe (as fractured as it is) are. Global economy can go bigger and there would be some wealth for all as long the new balance of power once reached stays stable. Many of the current global conflicts are a result of this system change and the vacuum created by US adjusting its global power position. Some of these conflicts rest on the problems caused by mistakes made in setting up the former world orders like Middle East and North Africa. I am from Balkans and trust me, these could be generational processes. Balkans had multiple wars at the time of the sunset of the Ottoman Empire which did not end until the end of the WWI and the settlement of the Vienna Congress, which was not done right, so it all repeated itself with the fall of the Berlin wall that marked the end of the two-power system.

As we are tracking these super cycles in history and economy, it is hard not to find some possible patterns that emerge as little cycles inside the super ones. I get worried that the pendulum does truly swing back and forth politically and economically as a result of these historical changes. When technological innovation disrupts the wealth distribution at the time that world order is transitioning a lot of things can go wrong if the powers to be make mistakes. Just as electricity, railroad and industrialization changed the world at the time, the internet of things and artificial intelligence are changing it now. The scale of wealth creation and the degree of inequality are very similar. Globalization, immigrants and outsourcing get blamed and the anger of those who feel left behind and forgotten fuels populism. The divide in the society grows and risks disruption to the development and growth. It took years, but in 19th century the system stabilized into what we call the Progressive Era where popular demand radically remade the balance between state and market by creating social protection, progressive taxation and antitrust legislation, which still supported the capitalist philosophy while creating a basic safety net and redistributing enough to slow down the rampant wealth divide. Some other regions were not that lucky. The political mistakes leaders made to satisfy the populous started a world war and a revolution. The consequences of the nationalism and soviet style communism of the time changed the world forever and erased massive amount of European wealth created over centuries. Sad to say, but it does seem that massive wars and natural disasters are the ultimate wealth equalizers. If I am correct, the populist pressure will turn on the tech companies.

Living with low interest

The bull of the bond market ended sometime in 2017 after a 30-year run. We believe good bond performance was due to a positive development to bond investors - One of the two main risks of bond investing, the interest rate risk, was favorable to investors, but becoming less favorable to savers. Interest rates were on their way down since the late 80s. Initially, this was a result of policy changes of governments and central banks, but the cause should be more related to changes in demographic growth, overall growth of the developed world and the inflation expectation changes caused by them.

Savers around the world face the same problem that our retirees do. Bank accounts, money-market accounts and funds, and all other short-term investment instruments are not offering a decent return anymore. Rates are lower than historically, in nominal terms because the inflation is lower, but also in real terms. Developed countries bond yields have touched a historical low this year, somewhere between 1% and a negative number. Lending your money to a government under a 10-year term could cost you. Central banks and economists don’t have enough research to suggest to us what the savers will do next to respond to this problem. Chances are they will have to do one of three things (or any combination of them): They can find some savings in their future budget to spend less - demanding a lower overall rate of return; they can save more now if there is a possibility; or they can invest more of their savings in risky assets and hope for better overall returns on their portfolio.

Another effect of low interest rates should be a lower overall long-term return on all assets. Total return on stocks or real estate is a sum of a risk-free rate (interest rate of short-term government debt) and the risk premium on the asset. If the risk-free rate is expected to stay close to 0-1%, then the overall return should be expected to turn out lower than the historic average. The effect on these expected returns on our retirement plans will be small as long as inflation stays low. Chances are that inflation will eventually start rising gradually and hopefully start pulling the interest rates up with it.

Please contact me with comments about the issues we touched on in this letter. Any questions arising from them are welcomed and they might help us to further tune your plans. Please do your best to stay healthy and well. Happy and joyful holidays to you and your families from all of us at Culov Wealth Management. We all hope that the coming 2021 will be a much better year than the one we just had.

All the best,

Emir Culov
Partner, Portfolio Management Director