“I am not what I am”, Iago proclaimed in Shakespeare’s Othello, and I am also thinking of similar lines proclaimed by Arthur Dimmesdale in Scarlet Letter, Jay Gatsby in The Great Gatsby, Emma Bovary in Gustave Flaubert’s Madame Bovary, or Anna Karenina in Tolstoy’s novel. What do all these characters signify by such proclamations? In rhetoric, such condition of undecidability is called aporia. In literature such aporia gives the characters depth and sophistication and uplifts the protagonists’ ambiguity and paradox into a crowning achievement.

Continuing from our earlier (Part I) assessment, we also discover an underlying ambiguity in the prospects for the year, despite the fact that the grand majority of the analysts expect double digit gains for the major stock indexes. Therefore, in this commentary you will read phrases like “on one hand, but one the other hand”, as well as “If however,…”

Let’s start our narrative then by looking back: 2020 was an abnormally positive year for equities that has lifted up the hopes for 2021. A return to normalcy, however (by the end of Q2), could be disappointing. The 2020 equity returns reminded us that despite 350K deaths (in the US) due to Covid-19, massive protests, political uncertainty, and declining earnings, the stock indexes care for what may be happening in the future over what has already happened. What are we confronting then in 2021?

On the positive side that may give a further boost to equities, we count vaccinations and therapies, stronger growth (between 4.2-5.3%) for developed economies, higher spending/sales, healthier profits (from about $136 to about $170 for the S&P 500), political stability, partial return to trade normalization, further fiscal boosts, a potentially weaker dollar (more than 50% of the S&P 500 sales are generated abroad), shares buyback, and dovish central banks that hold the line of zero rates and may even purchase more bonds. Furthermore, and from a technical standpoint, we may say that the market breadth as well as the Put/Call ratio may also point to higher gains.

On the other hand, it is possible that this year’s expected gains/profits are already reflected in stock prices and hence the prospects for double digit gains may be limited. In addition, stronger growth may push the long-term rates (which the central banks do not directly control) higher, which in turn will reduce valuations and possibly the market multiple for high-priced stocks, especially in sectors like technology and communications services, if not consumer discretionary too. Just two stocks (Apple and Microsoft) make up close to 12% of the S&P 500 index, and if we add the rest of Amazon, Facebook, Netflix, Tesla, and Google, then we are dealing with a fat tail risk given that their total weight is close to 25%.  The way that the indexes are constructed signifies bias and the market may not accurately reflect recovery’s pace if those stocks stumble. If they were to drop, e.g. due to higher rates or contracted multiples, then the index itself would have a hard time showing significant headway, as those leaders may downgrade investors’ appetite for risk. An antidote to such scenario would be to buy stocks sensitive to Covid-19 (such as those in the traveling, entertainment, and oil sectors) and thus play the expected recovery scenario while supplementing the portfolio with industrials, banks, and renewable energy names. The problem of course is that recovery may be stalled and thus this beta-seeking Covid-19 strategy may backfire in sectors like energy and traveling, given that some names like ExxonMobil, Chevron, BP, Shell, are still down, on average, more than 35%.  Another risk of course is that if the recovery stalls and/or rates increase, we may be seeing rising bankruptcies (as companies won’t be able to meet their obligations) which could shake up the market too. 

On the fixed income side, the situation is equally ambiguous. Bonds seem to be more overpriced than stocks, their yields are extremely low, thus overall, they are pretty unattractive, especially when someone takes into account that the yield on the S&P 500 (let alone of some particular stocks) exceeds the yield of bonds. Spreads between investment-grade and high yield bonds are tight and thus for the risk they offer they also seem unattractive. If, however, turbulence starts and persists for more than two weeks, investment-grade bonds will continue playing the safe harbor role as will gold and silver.

On the fixed income front, we would prefer inflation-linked TIPs, which may offer better prospects than traditional bonds, given the possibility of higher inflationary pressures by Q4 in 2021 or by Q1 2022. The fact that 25% of the cash that is being circulated represents new money printed by the Fed, as well as the stimuli (past and forthcoming), along with the consumers’ prospects of higher spending and the Fed’s new policy of tolerating higher average inflation levels, makes us think that inflation – per previous commentaries – may exceed the Fed’s targets. If that persists, then we see the Fed tightening by mid-2022, which the futures market may be able to pick up by the end of Q3 this year. If that were to happen, then we may be facing a recession by the end of Q3 in 2022 which will force some hard choices given the amount of refinancing that needs to take place in the midst of rising rates by then. However, in the inflationary scenarios, we should also consider the disinflationary forces of technology and demographics (graying is synonymous with savings rather than spending). Hence for now, our bond strategy is to buy TIPs, retain some bond as well as our preferred positions, and add to precious metals later as a further protection. 

“So, what about emerging markets?” someone may ask. The reality again, is that emerging markets indexes are biased too, since close to 70% represent companies located in China, S. Korea, and Taiwan. If recovery is strong in the developed markets, then we expect higher exports for the emerging markets which should uplift their prospects. In addition, the dovish Fed advances their prospects as a tail risk of a stronger dollar is taken out. Emphasis could continue on tech/cloud/internet related names but should also expand in names related to digitization (including digital payments) and possibly health care, as higher standards of living uplift the prospects of higher health-related spending.

What is then our overall conclusion given the above ambiguities, arguments and counterarguments of Iago’s “I am not what I am”? For the first few months of 2021, we believe that the equity markets will continue reacting positively to the prospects of growth and higher earnings. However – as of now – as the year unfolds the enthusiasm may subside and thus caution may be needed. Of course, hedging with options is recommended, especially if volatility rises due to economic and/or geopolitical developments.

Happy New Year and may the rays of hope become stars of joy throughout 2021!