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Economic growth in the developed world is more reliant on the service sector than on manufacturing. In order for the consumer driven western economies to thrive, everybody needs to consume. It goes without saying that COVID driven shutdowns have decimated a large part of the service sector. Furthermore, as of today, only the high income groups are doing well, while the lower income groups, who have borne the brunt of the COVID related job losses and often infections through job related exposures, are largely suffering the most. Given the lower and middle income earners are the most prone to consume any incremental income they get, any impediment to their ability to spend is a detriment to the overall economy .

Money supply growth has exploded around the world thanks to the largesse of central banks and government cheques issued to offset the impact of COVID on the economy. This is leading many economists and strategists to forecast runaway inflation. This view largely ignores the simple fact that “easy money” and low interest rates have been symptomatic of the global economy for a number of years prior to the pandemic, with both the rate of economic growth and inflation slowing throughout. Our, now clearly non consensus view, is that longer term inflation will continue to struggle because of the simple fact that the amount of debt has exploded everywhere in line with the increased money supply. Sure, once the pandemic is behind us, increased savings and pent up demand may collide with limited supply of hotel rooms, restaurants and airline seats for a small period of time. The question is whether that will be sustainable. Certainly when it comes to most goods there should be little pent up demand given even octogenarians are now shopping on Amazon.

The fact is, ultimately when your balance sheet is saddled with an extraordinary level of indebtedness you reach a point where you stop borrowing or borrow significantly less, irrespective of interest rate levels. When this happens stimulating economic activity and inflation become increasingly more difficult no matter to what degree the system is flooded with liquidity. The last decade is proof of that.

This is not to say that a sharp cyclical recovery or exceedingly weak currencies when combined with massively accommodative central banks will not create some temporary lift to prices. But, for inflation to become entrenched, the upward economic momentum must ultimately be sustainable. With all the debt outstanding, it will take only small movements in interest rates to the upside to cause a sharp contraction in economic activity, as the burden of interest payments will rise dramatically; especially with governments and heavily mortgaged home owners.

All over the world central banks have pushed pedal to the metal driving balance sheets off the charts. Money supply has never seen such an unfettered expansion. On the opposing side however, money velocity remains anemic, as those that went into this already with record amounts of debt, are not really interested in borrowing even more. As many people (still with jobs) have restrained their spending under lockdown given the threat of catching the virus, savings rates overall have never been higher. Corporations too, are being prudent and not spending as uncertainty is the biggest killer of planned capital expenditures. Cash hoarding is the order of the day. Governments can supply lots of cheap money, but they cannot force anybody to either borrow that money or spend it. Therefore, inflation is truly not a concern as of now. Those that claim it is, look only at money supply growth. We would counter that money supply also grew during eras of disinflation. If you look at the velocity of money, it has been going down for the better part of two decades.

2020 was characterized by strong sales of homes and autos. Large purchases usually done with debt and encouraged to take on the maximum amount of leverage possible by low interest rates and special government programs. Pent up demand may be a small boost to inflation after lookdowns but increased leverage makes it likely that we return to anemic economic growth after a short cyclical bump. Low rates will be sustained as long as inflation is contained. There is likely no other option for central bankers given the indebtedness incurred. Higher rates would inevitably lead to economic catastrophe. In this environment, we would expect corporate returns to fall as growth becomes increasingly scarce and companies are sustained only by government funding irrespective of their viability. Companies that can grow will become increasing sought after and be rewarded with higher valuations.

To conclude, the conventional view in today’s market is that a strong cyclical rebound will lead to rising inflation and commodity prices creating a rising tide that will lift all boats causing the out of favour “value” segment of the market to produce prodigious returns, while multiples of high flying technology stocks will finally succumb to rising interest rates and a fierce market rotation. Given the likelihood for a short lived post COVID economic bump as previously discussed, we would see this as a head fake before growth reasserts it’s dominance later in the year.

For the markets to continue to do well in 2021 we will need the following to happen:

1. Vaccination of the population at large against COVID – likely, but not until year end.

2. A consumer willing to spend again in the depressed service sector – gradually once vaccinated.

3. Accommodative central banks for a few more years – likely for at least 2021.

4. A recovery in all sectors of the economy – likely but slow and gradual with commercial real estate likely to be an outlier which could act as a drag.

5. Strong earnings reports from companies to justify extended multiples – challenging but possible at least for some sectors of the economy; expect COVID beneficiaries to give back some gains to the benefit of those that will benefit as life goes back to normal.

The fast adoption of technology over the course of 2020 should lead to productivity gains. Lower costs of commercial real estate and rents in general will increase margins. This should all provide much improved earnings growth for 2021 and beyond. Lower interest rates will help to anchor higher multiples. However there is movement taking hold in corporate board rooms around the world towards taking care of all stakeholders, rather than just the shareholders. This will bring margin pressure from much needed income increases for the lower end of the workforce across all industries. Some sectors will be able to pass on increased labour costs in prices, others will not.

All in all, we expect 2021 to be an extremely volatile ride when it comes to investing. Vaccine distribution to date has already been disappointing to say the least. COVID is still rampant driving more bankruptcies every day, irrespective of all the cheap funding available. Structural changes in the commercial and office real estate markets are bound to have negative effects that reverberate across the economy. 2020 has been a reset year in how we work, how we shop and most importantly, what we value. Consumer behaviour and spending patterns could change in ways we do not forecast. The political landscape remains full of landmines across the world.

We are optimistic, but remain in the cautious camp. Trees do not grow to the sky and the valuations of the best companies are not cheap. Many companies, that have yet to deliver earnings to justify their multiples, are even more expensive than the highest quality companies. Speculation is rampant based on the high margin levels in retail investment accounts. The worst quality companies, professionally shorted by the hedge fund community, are being ramped up to insane pricing by the Robinhood Hoodies (mostly young kids) borrowing to get rich in the stock market by buying what their peers are recommending on Reddit because “stocks only go up”. These are all warning signs that 2021 could be shaping up to be a roller coaster year for investors.

The Summerhill Team


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