At the end of 2019 we itemized our list of short-term worries to include: no trade agreement with China, potential Brexit fallout, a flat yield curve, corporate earnings disappointments, Trump impeachment proceedings, Hong Kong protests and Federal Reserve mis-steps. Do you notice anything missing from this list? Yes, no mention of the item presently in the forefront of everyone’s mind who works with economic, social and political trends: Covid-19.
In July, we read an interview with Glen Hiemstra, a local ‘futurist’ who makes his living interpreting trends. To the question about dealing with Covid & re-opening the economy he said:
“It’s going to be a very cautious restart for most people. One year from today, we won’t be traveling much internationally or even nationally. Assuming there is a robust vaccination program, this (pandemic) will be in our rear-view mirror in two to three years. Then there will be an explosion of joyful business activity. So by five years from now, I see a new renaissance, an exuberant rebirth of the national economy and possibly global.”
So what are the signs that our economy is improving?
■ The Federal Reserve of St. Louis Stress Index peaked in the first quarter. Quick action by central banks allowed normal financial functions to resume which provided credit to large corporations that could access capital markets.
■ The weekly number of new jobless claims declined unexpectedly for the second time in a row on December 31; this triggered a bounce in the U.S. dollar following the December 31 multi-year low against the dollar’s major peers.
■ We have suggested that we could look to China’s recovery as a possible template for ours. China’s manufacturing activity rebounded strongly in March and continued into year-end. And improvement is not unique to China as Germany’s manufacturing sector continued to rise.
■ Strategas Research has pointed out that personal savings has increased significantly over the last few quarters and while it is concentrated in wealthier households it may well be pent up demand for goods & services. If this ‘’pent up demand’ is coupled with a continued improvement in jobless claims then the recovery could broaden out to lower-wage earners and the makings of a continued rally in risk assets could be in store.
■ The Fed’s December projections showed a stronger recovery moving forward. However, officials continued to caution that the outlook faces elevated risks and is sufficiently uncertain as to warrant rates remaining near zero through 2023. They opted to keep the size and duration of asset purchases unchanged but did provide a stronger commitment in new forward guidance to continue the current pace of purchases until ‘substantial further progress’ towards their twin goals are achieved.
What is likely to happen to bond prices in this environment?
Given the Fed’s outlook indicated above, we look for bond prices to move more on credit quality issues than on interest rate changes in the coming quarters.
■ Corporate bonds’ credit quality could be hit by an expanding recession and tighter lending criteria. Something to keep a close eye on as we begin to resume more normal social and economic activities.
■ Municipal bond issuers have a unique set of challenges. The Federal stimulus passed by Congress in late December doesn’t include any direct cash to states & cities leaving them to rely on the economic boost that the aid package promises to fend off some of the deep spending cuts and budget shortfalls caused by the pandemic. This means the recovery for municipal governments will be felt unevenly and dragging into 2021-22 for those areas hardest hit by Covid-19 (per the National Assoc of State Budget Officers). Which areas will be hurt the most? Those with revenues tied to battered sectors such as travel, tourism and energy.
Core Equity Strategy
In our Core Equity Strategy we have remained pretty fully invested through 2020. Cash levels have stayed low and we have continued to be rather agnostic in terms of growth versus value. At December 31 we owned 40 stocks – 14 of which were considered growth stocks by Frank Russell Co., 12 were categorized as value and 14 were listed as both growth and value. Your portfolio includes prototypical growth names like Apple, Microsoft, and Alphabet (Google) as well as deep value names like J.P. Morgan, Verizon, and Eastman Chemical. Our focus has remained on individual issues and diversification versus sector, not growth vs value or cash vs equity investment (market timing). As “value” ceased being a dirty word in investment circles starting about September 1, the strength in the domestic equity market broadened considerably. In other words, it’s been a far more level playing field for the universe of stocks out there and it is not just a small number of issues that are leading the market higher. This also underscores the fact that, as investors, we must be willing to be flexible and not wedded to one singular issue.
Right now, most of the optimism in the stock market is based upon a successful fight against Covid-19 and a return to a more normal economy in 2021. It is this better economic data that we will need, we believe, to see a continuation of the rotation into more of the cyclical names. We are currently overweighted in two sectors – technology and healthcare. In looking at which sectors have historically outperformed the overall market in periods of rising interest rates, high inflation and a falling U.S. dollar, all of which we have been anticipating, technology has been the #1 performing sector. For this reason, as well as the healthy free cash flow characteristic of these companies and our ability to find still-reasonable valuation for a number of tech names we remain quite comfortable remaining overweighted by some 6 percentage points in technology. While we own some high-profile tech names like Microsoft (eight years) and Apple (seven years) some of our better performing tech stocks have been pretty under-the-radar including TE Connectivity (electric components), Lam Research and Applied Materials (semiconductor equipment), Texas Instruments, Broadcom, and Taiwan Semiconductor (semiconductors) and Accenture (management and technology consulting). In the case of healthcare, we view it simply as an area that will see more dollars allocated toward it due to the aging of the population, among other reasons. We are spread around biotech, drugs, devices, and services. Strong balance sheets and great free cash flow are prevalent. We are underweighted in consumer staples, energy, and real estate.
Dividends received a lot of attention and press as the Coronavirus impacted our economy early in 2020. While much of the negative activity was centered around travel stocks and financials, clearly not all U.S. companies chose to eliminate, reduce, or just maintain their dividends. During the middle two quarters of 2020, 60-75% of our companies reported increased free cash flow over the corresponding quarter of 2019. This helped allow 31 of the 38 dividend paying companies that we own (Alphabet and VMware do not pay dividends) to raise their dividends since mid-March 2020. In addition, another five companies that are on an annual cycle will, we believe, raise payouts in January and February of this year! Since dividend growth is a key characterization that we look for, it is encouraging that these companies continue to have a mindset of returning a higher amount of their free cash flow to shareholders. The yield in the equity portfolio is 2.0%, nicely above the 1.1% yield on the 10-year U.S Treasury, but not the highest yielding group of stocks.
Growth Stock Strategy
Growth stocks delivered a very strong performance in 2020, as many of these companies benefited from the consumers switching to working, shopping, and streaming from home, as a result of the pandemic.
We see some potential risks ahead:
■ Some of this surge in demand has likely pulled some growth from the future years, and we could see growth for some of these businesses flattening out in the near-term.
■ Valuations for growth companies have expanded as interest rates declined and as they were viewed as the beneficiaries of the pandemic and “the only game in town” against the bleak overall economic picture. As investors look to other side of the pandemic and the recovery in the broader economy, we could see some rotation from the outperforming growth stocks to some of the last year’s laggards. In fact, we have seen some of this during Q4, with the value stocks outperforming.
But also opportunities:
■ Accelerated growth during the pandemic has allowed some companies to solidify their leadership position and widen the gap between them and any future challengers.
■ Some growth companies (e.g. transportation disruptors, payment processors, medical technology) have been negatively affected by the pandemic and should see their businesses and stocks recover as the broader economic recovery takes hold.
We continue to keep an eye on the big picture and believe the portfolio is well positioned to take advantage of some of these opportunities while mitigating potential risks.
We hope this finds you and your loved-ones well and looking forward to a less stressful 2021. All is well at KKRA and we are looking forward to helping you with your investment