Roaring Twenties Revisited
18.12.2020 19:34 - GAMCO International SICAV
How does one even begin to summarize 2020? In economic terms, it was a year that began with a 3.6% unemployment rate, the lowest in fifty years, and is ending with nearly $1 trillion in lost economic output and over ten million jobless Americans. In human terms, the cost of the COVID-19 pandemic has been immeasurable, claiming over 300,000 lives, doubling the number of families experiencing food insecurity and straining relationships with family and friends. But appropriate for this time of year, there is hope. While several dark months remain, the proverbial light at the end of the tunnel draws closer. Economic growth is recovering, the stock market has rebounded and vaccinations have commenced. To paraphrase Winston Churchill, we may have reached the beginning of the end.[*]
The coming year is its own new beginning that brings with it a renewed economic cycle and novel ways of working, shopping and playing. Many changes will be permanent, but established patterns are difficult to alter. Indeed, we would argue the pandemic has accentuated the need for human companionship and discovery, and, combined with pent-up economic demand for a variety of goods and services, portend a revived Roaring Twenties. A new domestic political order, a more assertive China and ceaseless technological innovation promise an eventful decade. (Y)our analysts and portfolio managers remain intensely focused on discerning these developments (sometimes even remotely!) while applying our PMV with a Catalyst TM approach, where appropriate, to generate attractive risk-adjusted long-term returns.
The Political Economy of COVID
Rather than recite the well-known events of the year, we revisit our observations regarding the recent acceleration of trends already in place – what we have termed the D’s:
Digitization – Lockdowns have forced sometimes reluctant consumers, businesses and governments to change the way we work, learn, interact, shop and recreate. The adoption curve for many technologies has been pulled forward and new markets have been expanded and created (e.g., connectivity, e-commerce, telemedicine, payment systems) to support “distanced” activities. The durability of these adaptations may be up for debate, but some new habits will die hard which is already impacting everything from worker migration to commercial real estate to what types of entertainment gets produced.
Disunity – A popular view holds that the fraying of America’s social fabric, abetted by globalization, rising income inequality and growing cultural differences were the underpinnings of recent political dynamics. COVID appears to have deepened America’s socio-economic divide with events around the recent election both indicative of and exacerbating our national discord. The defeat of COVID, economic healing and a more conciliatory tone from Washington may reduce the volume on these debates but we would not expect harmony any time soon. Perhaps most importantly, capitalism faces an existential threat with a large portion of the population not “bought in” to the present system. The implications for our country’s human capital and educational priorities, future policies and even the dollar’s reserve status are stark and worth consideration.
De-globalization – Travel bans and vaccine nationalism have joined trade barriers as the latest incarnations of beggar-thy-neighbor policies. The new administration may take a different tack toward international relations, but the US rivalry with China is probably only beginning. Much as the US may be splitting into “two Americas” the world may cleave into US/Western and Chinese spheres of influence carrying with it significant consequences for trade, supply chain designs, inflation and security costs.
To these we add two other trends that have gathered energy in the recent storm:
Debt & the Dollar – The fiscal response to the pandemic, in the form of the $2.2 trillion CARES Act, arrested the severity of the recession, but when combined with a reduction in all levels of tax revenue, deepened our deficit. At 130% of 2019 GDP, the $27.4 trillion national debt ($214,000 per household), exceeds even the 120% level recording during World War II. To get this figure under control will require some unlikely combination of fiscal modesty, increased taxes and inflation (itself covert taxation – also known as seigniorage – that transfers wealth from savers to borrowers). The velocity of the printing press (minting money?) and the level of aggregate demand are partial determinants of inflation; both will be in high gear next year, providing the greatest chance for unexpected price instability in perhaps decades. We also continue to watch the dollar, which may weaken with varying impacts on corporate profits, exports and consumption from abroad.
De-carbonization – Pushed down the headlines in 2020 were the record 4.2 million acres burned in the California wildfires and a record thirty named Atlantic storms, ending with Hurricane Iota. We will leave it to scientists to draw a definitive link between these and other events and man-made climate change; nonetheless, it is perception that matters, and the emerging generation is singularly focused on reducing humanity’s impact on Planet Earth through changes in behavior and investment preferences. We have been attuned to this appetite for some time, launching our first SRI (Socially Responsive Investing) products in 1987 and following with ESG (Environmental, Social, Governance) products. We recently punctuated our commitment to environmental stewardship with the launch of an actively managed ETF called LOPP (Love Our Planet & People) – an excellent gift for those interested in both the planet, people and profits.
A Path Forward
Early in the pandemic, the twin uncertainties of the looming US elections and the scope of COVID infections clouded our outlook for the economy and earnings. We will have to wait until the Georgia run-off on January 5th to determine whether the Senate will remain Republican (52-48 or 51-49) or become evenly split with Vice President-elect Harris as a tie-breaker. However, three Republicans from blue states and three Democrats from red states likely means a divided government with extreme impulses from either party moderated. Nevertheless, an increase in corporate and individual taxes seems probable over the next two years. We would also expect to see a third stimulus package (assuming the second package now being negotiated comes to fruition), possibly with an infrastructure focus. Former Federal Reserve Chair Janet Yellen’s move to Treasury Secretary paves the way for coordinated and accommodative fiscal and monetary policy.
Regarding COVID, we posited that some form of normalcy would return when we reach a “point of indifference,” i.e., when a combination of social distancing, reliable treatments, available vaccines, acquired immunity and quarantine fatigue encourage individuals to attend in-person events, travel, etc. Some may have reached that stage, but challenges remain: How much vaccine will be available and to whom (including children)? Will the shot(s) prevent infection or just disease and for how long? Are we missing any long-term side effects? Will the virus mutate and become endemic? No one can yet answer these questions, but the efficacy of the initial vaccines and the speed of their delivery make us think commerce will increase by mid-2021.
Unfortunately, even in the face of rising asset prices and an overall increased savings rate, an extended economic shutdown has strained the balance sheets and impaired the skills of many employees and small business owners. Restarting sustainable economic growth will be a lengthy process as uncertainty about the trajectory of the virus is a barrier to the necessary budgeting and planning. In the meantime, the economy remains vulnerable to a host of shocks from China trade tensions, instability in hot spots such as the Middle East and an unmanaged Brexit. On the other hand, we expect a forceful rekindling of animal spirits. Bar keeps may have had a miserable 2020, but they will surely be in demand by the summer.[2]
Mr. Market
It took COVID to end the United States’ longest bull market at 131 months, only to give way to its shortest bear market at just over one month. After declining 34% peak-to-trough February to March, the S&P 500 is now up 17% for the year, 64% off its March low. Ever the discounting mechanism, market participants are clearly looking forward to easy earnings comparisons in 2021 and beyond. But the market is also being fueled by two powerful impulses: TINA (There Is No Alternative) and FOMO (Fear of Missing Out) as low interest rates continue to force savers out of cash and bonds into equities which are gaining momentum.
The current S&P 500 2021 price/earnings multiple of 22x is high compared with history but more defensible given the level of rates and the nascency of the economic cycle. The recent IPO and SPAC frenzies, extreme hype around certain electric vehicle and everything SAAS companies and increasing involvement of retail/Robinhood investors are emblematic of a bubble but not one that encompasses a majority of the market.
Further complexities exist below the surface of the market. Growth stocks outperformed Value stocks for much of this and the last ten years, with the five largest companies in the S&P 500 (Apple, Amazon, Microsoft, Alphabet/Google and Facebook – the “Big Five”) at times comprising almost one-quarter of its weighting and more than 100% of its positive return. While the low interest rates and technological disruption that have underpinned Growth’s dominance remain, other dynamics are changing. Factors including extreme valuation disparities, an early cyclical turn, greater regulatory scrutiny of the Big Five and stirring inflation expectations with a steepening yield curve have led Value (and smaller capitalization stocks) to perform better than Growth since September and could set the stage for a more lasting Value comeback.
Our Approach
As synchronously as stocks declined at the outset of COVID, the rebound has not been as uniform. Significant valuation disparities remain in the market and economic, political and social changes are as violent as ever. This should lead to greater opportunities for active managers over the coming years. We think greater returns are available looking beyond just the Big Five or index constituents such as Tesla that passive managers will be forced to buy. Finally, we think M&A activity, deferred in some cases but made more urgent in others as buyers and sellers contend with altered competitive landscapes and divergent balance sheet positions, should boom in 2021. Owning consolidation candidates has traditionally allowed us to capture excess returns where we harvest positions regularly at irregular intervals.
While we are operating effectively and efficiently on a partially remote basis, we look forward to engaging with companies in-person when appropriate. We think our corporate relationships, built over decades of industry specialization, have been an advantage in remaining in touch with managements through this crisis. Like many, we have had to learn new ways of conducting research, but our process has always been adaptable to new technologies and trends. What has not changed is our disciplined application of cash flow-based valuation methodologies. That should serve us well as the market gyrates but ultimately rotates toward Value stocks.
Conclusion
Having shared our views on how the world might evolve, we turn to how we think it should unfold. We hope a collective effort to eliminate a pathogen that has caused so much economic and emotional pain unites rather than divides us going forward. We want the political class to make responsible decisions about the debt burden we leave our children while preserving for them a healthy environment with equal opportunities for advancement. Finally, we would like to see faith restored in a free-market system that, albeit imperfect, has lifted so many out of poverty and made our nation great.
Although portfolios ultimately ended higher than where they started the year, we are glad to be turning the page on 2020 and are reminded of another musing attributed to Churchill: “When you are going through hell, keep going.”
[*] Churchill made his full observation “Now this is not the end. It is not even the beginning of the end, but it is, perhaps, the end of the beginning” after Rommel’s ejection from Egypt in November 1942 to suggest the British were somewhere in the middle of the war. We feel confident we are further along in our own fight against COVID. Note we believe World War II references keep our current sacrifices in perspective.
