Equities in 2021: Prepare for potholes on the road to recovery

Compared to 2020, which was a year of economic retrenchment, 2021 is shaping up to be a year of economic recovery.

While new strains of COVID-19 are emerging and populations globally still face some restrictions on their daily lives, there is a light at the end of the tunnel as countries around the world have started the gargantuan task of inoculating hundreds of millions of people.

While this is a very welcome and positive step, in our view, there may still be reasons for investors to remain cautious. Last year, despite the initial shock to equity markets in March, most indices recovered and rallied hard into the year-end. This was despite substantial falls in earnings that were triggered by the coronavirus pandemic, meaning that on naive valuation measures, many markets ended the year looking very expensive.

While there are expectations that earnings will recover to meet these valuations, there may be some price volatility if investors are disappointed in any way. In addition, it is not unforeseeable that there may be impediments to the rollout of vaccines; the recent spat between the UK and European Union highlighted the fragility of the global vaccine supply chain, and many emerging markets have yet to start vaccinating at the same rate as more developed nations. The potential for new variants to emerge and infection rates to start rising could yet cause further volatility in global markets.

As a result, our view is that investors should potentially consider positioning their portfolios to capture possible market upside but maintain the potential to mitigate downside risks.

Managing risks in equity portfolios

While it is relatively easy for investors to achieve exposure to equity markets through passive vehicles, we believe that in this environment investors are best served by an active approach to investing. While index-based investments have some attraction – cost and simplicity among them – there are drawbacks that an active management approach could potentially avoid.

These may include exposure to bubbles and avoidance of low risk and poor-quality companies, for example. However, as with any active approach there are times when market events may go against the strategy, and 2020 was an environment that tested quantitative investment approaches such as ours. Quantitative, or systematic, strategies seek to exploit inefficiencies across a wide range of stocks, and the concentration of investor interest in mega-cap technology names as some of the winners from COVID-19 – with certain mega cap growth stocks growing to almost a quarter of the S&P 500 Index – was extraordinary.

For low volatility quantitative strategies, this lack of market breadth was compounded by the subsequent resurgence of risk appetite seen from November, triggering a rotation into the most distressed (lowest quality) part of the market. As active managers, we focused research into more dynamic ways to model volatility and control diversification, to potentially withstand similar situations in the future.

Another interesting feature of 2020 was the sharp rise in demand for stocks that are well placed in the fight to tackle climate change, particularly after the election of President Joe Biden in the US. We believe it is important to incorporate environmental, social and governance (ESG) analysis alongside traditional security analysis as the two are complementary. We believe ESG data can identify potential risks - and opportunities - beyond technical valuations, providing insight on issues such as reputational risk and identifying companies that are leading the way on ESG issues. This is a structural change that we think will become increasingly important as we move through 2021.

A long-term perspective

The extreme market events of 2020 provided a real acid test for many investors. We believe that the strength of the recent recovery, driven as it was by supportive fiscal and monetary policy, is likely to be short-lived, and 2021 should see some moderation from the bust and boom of 2020.

Looking forward, we see 2021 as a year of recovery for markets, albeit with some potential potholes in the road ahead. While there is optimism around a COVID-19 vaccine, the potential for new strains and any hindrance to economies fully reopening is likely to temper investor sentiment.

As we move through 2021 and into 2022, the role of stimulus should shift from recession mitigation to growth generation across a broad range of economic segments. Such an environment should improve equity market breadth, supporting a wider group of stocks and investment styles than in 2020, where returns were dominated by a narrow band of mega-cap growth stocks.

We expect the recent support for low-quality investments to be short-lived once the initial vaccine euphoria fades. The COVID-19 crisis has boosted the profitability of some quality-growth segments of the market such as healthcare, software, and consumer technology. Rather than reversing post-pandemic, we believe the crisis has acted as an accelerant to existing structural trends, which should provide continued support for quality-growth. However, the fact that quality remains relatively expensive, in our view argues for an active approach.

Looking ahead, therefore, we believe that the combination of an improving environment for quality and the growing focus on environmental issues by the new US regime will be supportive of sustainable investment strategies, providing structural support for future success.