With one son currently enrolled in the Royal Canadian Army Cadet program, two having aged-out after the age of 18 and me as a longtime civilian volunteer, the Jain household is accustomed to the idea of being instructed to hurry up only to then have to wait again.

With the vaccination effort now underway, people and economies are eager to resume normality but have to contend with a painfully slow rollout. Future-oriented capital markets, however, aren’t subject to stay at home orders and have been shifting to price in a post-pandemic world since November 9, 2020 when the first vaccine announcement was made. This helps explain the apparent “disconnect” between a struggling current economy and equity markets that are close to peak levels. Now that the market has hurriedly priced in robust recovery, it now has to wait for that recovery to unfold.

Through much of 2020 we were raising equity exposure in our asset allocation model due to a combination of attractive valuation and declining uncertainties. Positive vaccine study results, resolution of U.S. election uncertainties, cresting of the current wave of the pandemic, additional fiscal stimulus, and ongoing support from central banks have been the main drivers of recent market performance.

Having reacted to so many positive developments, we now find some segments of the marketplace overvalued, others fully priced, and the sectors that remain attractive are becoming fewer. As a result, our short-term enthusiasm for the equity market has waned and we have decided to modestly reduce investment where we believe further upside is limited. With a multi-year economic recovery ahead, and because our medium-term outlook remains favourable, we intend to redeploy proceeds from recent sales into attractive equity opportunities as they arise. Our recent portfolio adjustments are listed below.

Markets are near highs, but some segments were left behind in 2020
While it is convenient to refer to the “market” as a homogenous entity, it is really a sum of its constituent parts. Markets can be segmented in many ways including regionally and by sector. The impact, or perceived impact, of the pandemic on a regional and sectoral basis resulted in vastly disparate performance in 2020.

As an example, the S&P500 index of large cap U.S. companies ended 2020 with a gain of 16% while the FTSE100 index of large U.K. companies fell 14% last year. Most other international markets performed somewhere between these two extremes (Canada’s S&P/TSX Composite was up 2.2% in 2020).

Similarly, the Information Technology sector of the S&P500 was up 42% in 2020 while Financials were down 4%. Since many of the disparities were triggered by the pandemic, it’s crucial to assess how market constituents may perform once the pandemic is behind us. The conclusion we’ve reached is that what worked in 2020 may not work in 2021.

Acknowledging that there are always exceptions, the Technology sector falls into the overvalued category in our opinion. Widespread adoption of technology expanded during the pandemic and many trends that were already in place before 2020 have accelerated. However, we think the valuation being applied to many growth-oriented companies may already be discounting significant future growth. It now remains to be seen whether these companies can sustain high revenue and earnings growth rates expected by investors once the pandemic fades and normalcy returns.

Compared to the enlarged weightings in benchmark indices such as the S&P500, our model portfolios are underweight Technology.
Ten technology companies in the S&P500 accounted for 70% of the index’s 2020 performance, signaling a significant lack of market breadth.

Since September, we’ve been repositioning portfolios for a post-pandemic world by sifting through industries that underperformed and have attractive risk/reward characteristics. Regionally, this has resulted in an increased allocation to international markets such as Europe and Asia, where valuation is relatively cheap and prospects for economic rebound are high. On a sector basis, we continue to see opportunities among banks, travel/leisure/entertainment, real estate, and select consumer segments. In addition to a strong likelihood of an earnings rebound, many of these sectors continue to trade below pre-pandemic levels. Portfolio holdings such as Bank of Nova Scotia, TD Bank, Citigroup, Shaw Communications also offer attractive dividends while we patiently wait for normalcy.

Our positive medium-term outlook is reflected in our modest overweight equity position. However, compared to broad market indices, we consider our actively managed portfolios to be defensively positioned and should experience lower relative volatility through 2021. While our current focus is on the economic recovery, we are researching secular growth industries capable of generating longer-term growth. These include clean energy, healthcare, and financial technology.

The Fed giveth and the Fed taketh away
As portfolio managers, our training and experience means that we habitually sleep with one eye open. While there are so many reasons to be optimistic about the future, there are always items on the risk side of the ledger that deserve our attention. In our opinion, the primary financial risk on the horizon is central banks taking their collective feet off the monetary stimulus pedal once the economy regains traction. Bold action by global central banks in the early days of the pandemic helped stabilize financial markets but had the unintended consequence of pushing valuation multiples and risk appetites higher.

Even though we expect central banks to start signaling the removal of stimulus in late 2021, the global bond market has already started to move in this direction in the form of higher yields on longer-term government bonds. Just as falling bond yields were a tailwind to asset valuation in 2020, rising bond yields could eventually become a headwind in 2021. Our current asset allocation and sector weightings reflect this expectation.