Equity accounts produced double-digit gains in the fourth quarter and outperformed a surprisingly robust market for the full year of 2020. Balanced accounts produced strong absolute returns as well. Looking at full year results, it is easy to forget that the S&P 500 declined over 33% within the first quarter as COVID-19 emerged on a world-wide basis. After that, unprecedented/unorthodox fiscal and monetary support paired with the hope of vaccines overcame the financial negatives. During the initial phase, we added to secular themes (online shopping, cloud-based software/services, and 5G cellular) anticipating that the new “stay at home” environment would accelerate pre-existing growth trends. Later in the year, we pivoted by placing emphasis on enterprises positioned to benefit from “reopening”/economic recovery. The Financial sector is a prime example.
Since the end of September, our weighting in Financials increased from roughly 8% to over 12%, and we enter the year with a significant overweighting. An improving macroeconomic outlook, resilient credit quality, and the resumption of capital returns combine to make these stocks attractive in our eyes. Starting first with the economy, we conclude that the factors necessary for a sustained expansion are coming into place:
- GDP is already rebounding from the lows of early 2020.
- Additional fiscal stimulus was enacted in December, and we anticipate a third and larger round to be added this year.
- The lagged impact of monetary policy (low interest rates/aggressive expansion of the money supply) will move from stabilizing to stimulating economic growth.
- Pent up demand was created during the pandemic while the aggregate consumer saving rate is historically high.
- After a slow start, vaccines should eventually be widely distributed. This would lead to reopening and an ensuing rebound in jobs for hard hit service industries such as travel and dining.
Turning to credit quality for Financials, a review of the 3Q20 results of the leading New York City money center bank, is illustrative:
Non-Performing Loans (mil) $ 5,601 $ 10,965
Allowance for Loan Losses (mil) $ 13,235 $ 30,814
Reserves/Loans 1.40% 3.11%
Net Charge-Offs (mil) $ 1,371 $ 1,180
For readers never enjoying careers as bank examiners (be thankful for that), please allow us to share our interpretation. Bad loans (Non-Performing) increased by about $5 billion from 2019’s third quarter. No surprise there given the pandemic’s economic impact and the loan losses already reported. More importantly, the bank’s reserves (Allowance) for those bad loans increased by over $17 billion or more than three times the amount that non-performing loans grew. This left the ratio of reserves to loans at 3.11%, dramatically improved from 2019’s 1.40%. In other words, the bank’s balance sheet is exceptionally well prepared for credit losses and, in fact, proved to have had excess reserves. Finally, the amount of loans written off in 3Q20 was actually less than 2019’s pre-pandemic levels. After large write-offs in the first half of 2020, this indicates that the worst is likely behind us.
Finally turning to capital returns, the Federal Reserve recently allowed banks to resume buying back stock after suspending repurchases early in 2020. Besides signaling confidence, this regulatory decision should provide a significant impact on financial returns (ROE) and stock prices. The bank analyzed above announced a $30 billion share repurchase plan, equivalent to over 7% of its equity market capitalization. This should increase over time as earnings grow.
In addition to the concentration in Financials, we also increased exposure to the Industrials and Materials sectors. These purchases were largely funded by sales of growth stocks and defensives such as Consumer Staples. This overall pivot in emphasis (stay at home to reopening; secular growth to economically sensitive) reminds us of the benefits of being a core manager rather than being locked exclusively into either the growth or value camp.
Given our view of the economy, it will not be surprising to learn that we see an upward bias to interest rates. We are not sure how high is up given the easy money policy of central banks across the globe. That said, up is up so fixed income assets are positioned with shorter than benchmark duration.
After the past year and a half brought us a trade war, impeachment, pandemic, and national election, it is tempting to assume that turmoil is behind us. Much of it probably is but be assured that 2021 will present its own challenges. New strains of COVID and frustratingly slow vaccine administration are currently receiving media attention. However, from a financial point of view, investors decided some time ago to treat the pandemic’s impact as ephemeral. It would take a lot to change that mindset. A different potential concern for capital markets was brought about by the Democratic Party’s win of both Senate seats in Georgia.
Democrats will soon control the House, Senate, and Presidency, a situation that investors historically view as unfriendly to corporate profits. However, markets have initially focused on the potential for additional stimulus given the future Majority Leader Chuck Schumer’s statement:
“One of the first things that I want to do when our new Senators are seated is to deliver the $2,000 checks…”
The next card to turn after that is when the concern over tax increases is likely to arise. President-elect Biden made no secret of his desire to raise taxes for corporations and higher income individuals and to change capital gain and estate tax structures. The ultimate magnitude of tax increases will be subject to negotiation given the Democrats’ slim majority in the Senate. In other words, they will only be as progressive as their most conservative Senator. However, the initial headlines are likely to show a big ask, or as Senator Schumer concisely tweeted, “Buckle up!” The timing is highly conjectural, and there are plenty of other issues on Congress’ plate as we write. Many variables influence capital markets so tax increases do not have to end the bull market. The point is that our mindset needs to be prepared to navigate choppy waters (as if 2020 was not choppy).
Entering the New Year with our equities well balanced between growth and value and our fixed income conservatively positive, we look forward to 2021.