Despite central bankers’ best attempts to tame the business cycle, economies continue to gyrate in cycles of boom and bust. During a growth period, many speculate when the next downturn will arrive and what will trigger it. The COVID-19 pandemic removed all doubt as to how this latest growth cycle would end. During 2020, GDP shrank dramatically in the developed world, with the U.S. declining an estimated 3.7%, the European Union down 7.5%, and Canada, shrinking 5.8%. The rest of the world followed suit.
Equity markets reacted swiftly, including the S&P 500 which declined 34% over 19 days in late February and into March, followed by a historic recovery and steady rise for the rest of the year. While this has been a positive year for North American investors, performance across other markets has been uneven. The valuations of certain technology firms have been driven into the stratosphere, while the rest of the sectors were divided into COVID “winners” and “losers”.
During this time, several economic, social, and environmental themes have risen to prominence. Massive financial stimulus engineered by governments and central banks helped reduce the economic suffering during the pandemic but have generated concerns about increased government debt. Social justice issues were front and centre, particularly in the face of inept and callous political leadership in the United States. The sudden shift to remote working has rapidly advanced the adoption of related technology, calling into question modern urban planning. Environmental issues focused on the threat of global warming and the replacement of fossil fuels have been elevated to the highest priority by both institutional and individual investors.
Looking into 2021, we remain cautious. This pandemic is far from over. While the arrival of vaccines provide hope, it will take much of the year to reach everyone. The priority is to vaccinate certain high-risk individuals while the majority of people, making up the heart of the productive economy, will have to wait their turn. Many small businesses have already failed, and more will surely follow. The significance of this cannot be under-estimated, as most workers in the developed economies work for small enterprises.
Governments have acted correctly by implementing massive stimulus programs, staving off societal calamity. But there will be a price to pay. Central banks in the U.S., Europe, Canada and elsewhere have purchased most of their government’s bond issues, leaving them with swollen balance sheets and materially expanded money supply. This, in combination with seriously increased government debt, has the potential to re-ignite inflation. Some would speculate that it could lead to a replay of the 1970s, when inflation averaged 10% per year. The counter argument is that the combination of globalization and technology will keep labour costs reasonable, acting as a break to the kind of vicious wage and price hike spirals that were experienced five decades ago.
Studies have shown that economies emerging from a pandemic can experience short, unsustainable bursts of inflation. Over the past year, some metal prices have already increased dramatically. As this pandemic subsides, oil prices may follow as the demand for transportation fuel recovers. These factors will bring an element of instability as we go through the recovery phase.
For much of 2020, we managed your portfolios with elevated cash levels. Our objective was twofold: to help protect against the downside and to buy during periods of market weakness to capture the upside. We are maintaining this strategy into 2021. The threat of inflation, even if minor, is leading us to favour the industrial and financial sectors. While not ignoring technology stocks, we tread warily in this space mindful of lofty valuations.
Many more challenges lie ahead, as the world eventually recovers from this historic pandemic. We will manage your portfolio with vigilance, protecting your capital and generating consistent returns.