A roadmap to navigating the COVID recovery

The market environment presents investors with a challenging juncture. In the short term, a combination of healthy consumer balance sheets, low inflation, low interest rates, and high liquidity provides a robust backdrop for returns. But in the longer term, different scenarios could play out requiring different approaches to portfolio management. For investors, complementing a portfolio of companies that work in specific scenarios with those that work in multiple scenarios offers a prudent strategy.

Checking the rear-view mirrors and the road ahead

In April 2020, we set out a plan to navigate the COVID-19 cycle. Our 3-bucket plan focused on companies that would perform well across the various stages of the pandemic: from virus outbreak/vaccine deployment, to recession and finally to recovery. Our diversified portfolio has performed well even as the cycle appeared to straddle multiple phases simultaneously. As we look forward to the end of the virus phase and the start of the economic recovery, we have an opportunity to review events and plan ahead.

Returns net of fees (%) (as at 31 January 2021)

Source: Fidelity International, Total net returns represent past performance only. Past performance is not a reliable indicator of future performance. Returns of the Fund can be volatile and in some periods may be negative. The return of capital is not guaranteed. Benchmark: MSCI ACWI (All Country World Index) Index NR (effective 1 November 2011). Benchmark between December 2006 and 1 November 2011 was the MSCI World Index, and prior to December 2006 and 1 November 2011 was the MSCI World Index ex.Australia. NR: NR at the end of the benchmark name indicates the return is calculated including reinvesting net dividends. The dividend is reinvested after deduction of withholding tax, applying the withholding tax rate to non-resident individuals who do not benefit from double taxation treaties

Short term outlook: A risk of becoming bearish prematurely 

Demand for technology devices and home improvements has driven product manufacturing and growth throughout the lockdowns and it will soon be supported by a rebound of the lagging services sector. Vaccines are providing a literal shot in the arm to people but also figuratively to equity markets. The speed and effectiveness of vaccine distribution will vary by country, but confidence is steadily rising as the programme rolls out without major hiccups.

Markets are planning for the reopening of society when 'revenge' buying and travelling will be unleashed and consumers will swap purchasing gadgets for dining out or holidays. Spending will be fuelled by positive aggregate consumer finances caused by forced savings and ongoing government transfer payments.

A combination of healthy consumer balance sheets, low inflation, low interest rates, and high liquidity provides a robust backdrop for returns. While market sentiment may already seem over-optimistic, it should be balanced with the consideration that as economies fully reopen, we could potentially have two of the strongest quarters of GDP growth experienced in developed markets. With the market near record highs and as uncomfortable as it is, the risk for relative return investors is becoming bearish too soon.

Medium term: A fork in the road

Beyond tail risks around hyperinflation and deflation, two opposing scenarios could develop. The first is a path towards conditions similar to the 1920s and the other is a return to the low growth era of 2012-2018. The challenge for investors is that these scenarios lead to completely different portfolio allocations. 

Scenario 1: The Roaring Twenties

While consumers have been spending (US personal consumption has recovered to 97% of its previous high), companies haven't been investing in capacity, creating shortages in, for example, personal computers and semiconductor chips. If corporations find the confidence to add to capacity and promised fiscal stimulus filters through the global economy, this could create a period of earnings and cash flow growth significantly higher than current expectations; mirroring the period post World War I and the global Spanish flu pandemic of 1918.

This 'Roaring Twenties' scenario would call for favouring cyclicals over defensives as earnings surprises are more likely, and for allocations to emerging markets and sectors such as financials, industrials and materials. Potential rises in interest rates would pose a risk to high growth technology stocks on lofty valuations that have been market leaders for several years, with turbo charged performance through the COVID-crisis.

Scenario 2: A replay of 2012-2018

The second scenario is more like recent experience. High debt, technological disruption and ageing demographics could steer the economy back towards a low growth world in a 'Japanification' of developed economies. In this environment, quality, growth and higher value stocks would be the cornerstone of an equity portfolio.  

Given central banks have committed to letting their economies run 'hot', scenario two is less likely. The direction of the market will be determined by which central bank is able to keep its nerve through the reopening quarters and continue with monetary and fiscal accommodation. History shows that one of the reasons why the US experienced the Roaring Twenties while the UK struggled through a lost decade was the relative differential in fiscal and monetary support.

However, there can be too much of a good thing, and there is a risk that even if the monetary spigots remain open, higher commodity prices as a result of shortages in supply could start sucking liquidity out of the system and reduce overall demand. We are already seeing shortages with automakers cutting production because of a lack of semiconductor chips and shortages of nickel and cobalt used in batteries for electric vehicles.

Expansions in supply always lag shifts in demand and any further increases in liquidity could be eaten away by higher commodity prices without any corresponding benefit for the economy. A stagflationary scenario (low growth, high inflation) that would be negative for equities and require a conservative barbell positioning in commodity-based sectors and defensives such as healthcare and food (bonds would generally perform badly as their principal value and coupons are inflated away).

Tracking indicators and returning to investment basics

When navigating uncertainty in markets, we favour diversification and detailed scenario analysis to construct a portfolio that can deliver consistent returns. Fortunately, there are signposts that can indicate which scenario is developing and we can adjust our portfolio appropriately.

Anecdotally, our conversations with companies across the globe give us a sense that corporate confidence is rising across sectors and geographies. Tracking economic indicators will show if economic momentum can be maintained beyond the initial consumer-led quarters. Growth in bank loans, PMI indicators and money supply trends could signal that the economy is transitioning towards corporate credit-driven growth and that conditions are in place for earnings growth, putting valuations at more reasonable levels.   

Maintaining investment discipline is crucial when markets approach a juncture. Timing the market at the best of times is risky, but during phase shifts is extremely difficult. Investors are more likely to be successful by returning to the fundamentals of seeking strong companies that can do well irrespective of the prevailing scenario.

Companies run by experienced and reliable management teams will find ways to outperform their peers in various environments. Look for companies focused on sustainability in industries with significant opportunities for growth and can effectively leverage technology. Biotechnology, renewable energy development, waste reduction and forward-thinking food consumption and production businesses all have huge growth potential. Companies located in emerging countries with relatively low debt burdens, also have a good chance of productive growth in the long term.

Strong convictions, loosely held

Given our holding periods generally tend to be 3-5 years, our portfolio is primarily exposed to companies that we believe will do well irrespective of the macro conditions. Complementing a portfolio of companies that work in specific scenarios with those that work in multiple scenarios is a prudent strategy.

In a market obsessed with themes and the next narrative, as contrarians we often find value in companies with less fashionable back stories but stand up to an interrogation of the investment fundamentals. These companies may be in unexciting areas and are frequently overlooked, offering diligent investors opportunities for sustainable growth at attractive prices. As the market transitions into a COVID recovery, investing requires patience and strong convictions, loosely held so investors retain the flexibility to adapt to whichever scenario plays out.

DISCLAIMER: 

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 ("Fidelity Australia").  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International.

Prior to making an investment decision, retail investors should seek advice from their financial adviser. This document is intended as general information only. Please remember past performance is not a guide to the future. Investors should also obtain and consider the Product Disclosure Statements ("PDS") for the fund(s) mentioned in this document before making any decision about whether to acquire the product. The PDS is available on www.fidelity.com.au or can be obtained by contacting Fidelity Australia on 1800 119 270. This document has been prepared without taking into account your objectives, financial situation or needs. You should consider such matters before acting on the information contained in this document. This document may include general commentary on market activity, industry or sector trends or other broad-based economic or political conditions which should not be construed as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be construed as a recommendation to buy, sell or hold these securities. Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment. Investments in small and emerging markets can be more volatile than investments in developed markets. This document may contain statements that are "forward-looking statements", which are based on certain assumptions of future events.  Actual events may differ from those assumed.  There can be no assurance that forward-looking statements, including any projected returns, will materialise or that actual market conditions and/or performance results will not be materially different or worse than those presented.  While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity's funds is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. References to ($) are in Australian dollars unless stated otherwise. Details of Fidelity Australia's provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website.

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