Investing in 2021: Willful Ignorance or Calculated Risk?

by | December 21, 2020

This has been a year defined by a sweeping pandemic, collapsing economic activity, unresolved political strife and soaring equity markets. The juxtaposition is jarring. In a year when so much went so wrong, can investors be accused of willful ignorance or is theirs a wager of calculated risk?

In our professional lifetimes, spanning collectively more than a half century of engaging with financial markets, we’ve witnessed way too many examples of individual or mutual investor madness to ever assume away willful ignorance. Yet, what has unfolded in 2020 looks more like calculated risk. What should be expected for 2021?

To answer this, we must first re-cap market performance this past year and unpack how it relates to the economic and institutional factors that drive asset prices.

The deadly global pandemic that rapidly spread in the first months of 2020 had no known medical remedies nor effective vaccines. Governments and societies had only one tool to mitigate death and suffering, namely social distancing. Enforcement required economically devasting lockdowns, compounded by collapsing demand as consumers and businesses reined in spending. Economies went into free-fall, as did global equity markets.

Policy-makers responded rapidly, and in unprecedented fashion, to the economic shock. Central banks slashed interest rates to historic lows, engaged in large-scale asset purchases and expanded purchase programs (backed by US Treasury guarantees in the case of the Federal Reserve) to previously ineligible asset classes, such as private sector debt securities. Fiscal stimulus ranged from 8% of GDP in Germany to 13% in the US and over 20% in Japan. The European Union made history with supranational spending initiatives.

Never in recorded history have fiscal and monetary policy come together in such concerted and sizable fashion. As the contours of the macroeconomic policy response became clear in the second quarter of 2020, global equity, credit and bond markets soared.

And yet, despite the impressive surge of global risk assets, their initial recovery was measured. Investors realized that financial and economic collapse had been averted. They were less certain that recovery was assured. Accordingly, giant technology, growth and quality stocks did best. More cyclical stocks and sectors, such as transportation, industrial, financial, smaller capitalization or value stocks lagged, or some cases continued to fall. Some even went bankrupt.

Investors remained cognizant of risk, even as they reached for opportunity.

Indeed, it was not until late October that the cyclical laggards assumed market leadership, with sectors such as Energy, Financials and Industrials springing to life and leapfrogging styles such as Quality or Growth. Their fourth quarter surge has been driven by two fundamental changes: (i) the development and distribution of effective Covid-19 vaccines and (ii) the anticipation that a Biden Administration brings greater predictability to US public policy and geopolitical affairs.

Accordingly, as investors saw reduced cyclical, policy and political risks, they began to rotate toward companies that would most likely benefit from a brighter earnings outlook and lower risk premiums.

Calculated investor risk-taking in 2020 had one other critical dimension—faith that low inflation and low interest rates will prevail for considerably longer. As bond yields fell to historic lows earlier this year, belief in ‘lower for longer’ was reinforced by recession, enormous output gaps, soaring levels of unemployment and unprecedented easing commitments by central banks. The latter included the Fed’s revised objective to pursue inflation overshooting.

Very low interest rates super-charged the TINA-effect (‘There Is No Alternative’ to equities) that pushes investors into global stocks. Institutional factors, such as the unrelenting need for pension funds to meet unrealistic long-term return mandates, reinforced the 2020 move into global equity markets.

Which brings us to the present and the outlook for 2021. Is the calculated risk-taking that broadly characterized 2020 warranted for the year ahead?

In the near term, investor optimism may dim. Vaccine production, distribution and acceptance could easily fail to meet lofty expectations. High rates of infection are already forcing some key economies, such as California’s or New York’s, to lockdown again. The outbreak of a new, more contagious Covid-19 strain in the UK has caused the government to introduce severe social distancing measures over the holidays, and other major European nations have banned visitors from the UK. It serves as a reminder that viral mutation could undermine expectations that the pandemic will soon abate.

Politics may also disappoint. Tense, last-minute Brexit or US fiscal negotiations could fail. Hard Brexit would not just deliver economically damaging outcomes for the UK and EU, it would also remind investors that the end of Trump’s presidency does not assure a return to global political and economic harmony.

But perhaps the biggest challenge for investors awaiting in 2021 is inflation. It may not be probable – inflation expectations and transmission mechanisms have been fundamentally altered in recent decades – but if inflation does recurr, it will challenge the investment landscape unlike anything seen in the past half century. Unexpected inflation would fundamentally erode government and corporate bond valuations, and simultaneously lead to a surge in equity risk premiums. In a world where inflation causes bonds and stocks to simultaneously plunge, investors will find little refuge.

In sum, 2020 has been a year of calculated risk. But periods of strong returns often spawn complacency and excessive confidence. Pitfalls, setbacks and secular changes are easily underestimated when investors are overly confident in their ability to calculate odds and calibrate portfolios. During 2021, we won’t be surprised if the investment narrative shifts from ‘calculated’ to ‘risk’.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognised for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides commentary and analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior business leader with two decades of experience growing and transforming businesses in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the Secretary of Defense. He is a member of the Council on Foreign Relations and the Chairman of the Advisory Board of Project Syndicate, the non-profit opinion page that provides world-class commentary to over 500 newspapers globally. In addition, he is a board member of the American Alpine Club and the Jackson Hole Community Housing Trust, and has served on the boards of the Gates-Cambridge Trust, the Seattle Art Museum, and a number of other non-profits. Friedman is a regular contributor to several newspapers and thought leadership groups and has published numerous opinion editorials on topics including economics, finance, philanthropy, and politics in Project Syndicate, Bloomberg, The Wall Street Journal, The Financial Times, The Guardian, CNBC, The South China Morning Post, The Chronicle of Philanthropy, and other news outlets. He is also the author of Babu’s Bindi, and The Big Thing, both children’s book. An avid mountaineer and rock climber for 30 years, Friedman has climbed some of the world’s highest mountains and led the first major climb to raise money for charity through an ascent of Mt. McKinley. He holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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