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 three-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. 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.

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.

The following combination factors will provide a robust backdrop for returns: 

• healthy consumer balance sheets,
• low inflation,
• low interest rates, and 
• high liquidity. 

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, becoming bearish too soon is a risk for relative return investors.

Medium-term: A fork in the road

Beyond tail risks around hyperinflation and deflation, two opposing scenarios could develop.

1. A path towards conditions similar to the 1920s 
2. 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. This has created 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. 

This could mirror 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 "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.

But there can be too much of a good thing. 

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. Any further increases in liquidity could be eaten away by higher commodity prices, without any corresponding benefit for the economy. This would result in a stagflationary scenario (low growth, high inflation) that would be negative for equities. 

Such an outcome would 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 between three and five 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.

Access growth and diversification benefits of global equities

The Fidelity Global Equity Fund seeks to invest in the winners of tomorrow by selecting companies with strong management teams, leading innovation and sustainable pricing power which operate in industries that we believe will benefit from future themes. For further information, visit our website.