November 2020

2020 was a tumultuous year, but significant grounds for optimism await for 2021. Two vaccines announced in November with an apparent efficacy of over 90% look set to bring back some normality to life and markets.

Below, we give Resonant’s take on 3 key investment decisions for 2021.

Key Decision #1: Wither bond allocation?

We don’t think so, at least not yet. We do however see risks to bonds building on the horizon, and we are keeping a watchful eye.

Bonds play a dual role in portfolios.

Firstly, they provide a stable income stream. Secondly, they hedge the business cycle risk inherent in Growth assets such as equities.

The stability of the income stream is both a strength and a weakness. It’s a strength because the risks of the holder not receiving it are minimal. But equally, the stability is a weakness because it is especially vulnerable to erosion by inflation.

This particular market regime, which began in 2009, has been characterized by 1) falling cash rates, 2) persistently low inflation (see figure below).

A switch in inflation regime, is ultimately the biggest risk to a long duration fixed income portfolio. This looks very unlikely next year, as it tends to strike with a lag on domestic recovery, so even if the recovery is explosive, this may only happen in 2022 at the earliest in our view.

And when that happens, rates will be slow to adjust as the RBA has consistently recently signaled a prioritization of full employment over inflation.

The second role for fixed income is to hedge risk assets. Concerns over its efficacy in smoothing the return stream of a diversified multi-asset portfolio are overdone in our view. What matters in this case, is the steepness of the yield curve (the gap between 10 year bonds and short term cash), rather than its absolute level, and the duration.

Australian sovereign bonds offer more steepness than most if not all markets, and the duration has been increasing across all fixed income segments. Finally the RBA has signaled its intention to target long term bond yields in a crisis, and will actively seek to flatten the yield curve, to ensure the currency remains competitive. That increases the likelihood of a capital gain if risk assets struggle.

Key Decision #2: Growth or Value?

One issue that has been gaining in air-time recently has been the rotation from Growth to Value. Investors are questioning how they should position for next year, and whether any Value rally can persist for most of next year.

Our conjecture is that the Growth outperformance YTD is more about sector positioning (IT, Healthcare, parts of Consumer Discretionary for Growth Managers, Energy, Financials, Cyclicals for Value managers) than Style. Resonant’s internal analysis shows that when neutralizing the sector effect, we actually find that this year has not been so bad for value investing. (see figure below, rising line indicates growth outperformance over value – this year has been flat, with some wild swings, especially November 2020).

Unfortunately, however, sector biases of the typical Value manager have been the single biggest detractor of outperformance in 2020.

Next year we expect this sector effect to neutralize – we actually anticipate a return to stock picking, as opposed to sector selection. Therefore we see potential for both Growth and Value managers to outperform, but see the outcomes driven more by pure stock selection, rather than sector selection. The key will be to have managers in the portfolio of both style stripes who can pick stocks effectively within sectors, rather than riding the wave of a lockdown.

Key Decision #3: Which tech?

2020 has been a ground-breaking year for tech companies, with the lockdown precipitating the take up of digital solutions for shopping, business meetings, social interaction and so forth.

The big question, is to what extent will these tech solutions be maintained in 2021 as conditions normalize?

We see a bifurcation in the tech space, with certain solutions going from strength to strength while other wither away.

One area where we see increasing pressure in 2021 is the Buy Now Pay Later (BNPL) space.

There is no question that the ability to better and more efficiently manage a credit pool is the key advantage versus traditional credit cards. However there appears to be a clear demographic bias to the users versus traditional banking (reference ASIC report). This is a double whammy for BNPL, firstly because responsible lending laws would make a similar allocation of credit from traditional banking an impossibility, so it has been able to become a major player extremely quickly, and secondly because the late fees have been so lucrative for much of the sector. We also know that demographically the same bias is evident in the fiscal stimulus, making the sector especially vulnerable as it rolls off early next year. (see figure below, and associated ASIC report here: ASIC report into BNPL sector)

Figure Above: BNPL usage by age relative to credit cards and overall population split (source: ASIC)

But the inexorable rise of software and cloud computing is here to stay in our view.

There will never be a better time for businesses to replace inefficient processes and infrastructure than 2021, bearing in mind the Federal Budget measures to facilitate instant write-offs.

Modernising equipment and process will inevitably lead to uptake in modern software solutions and businesses look to build for the future.