Letter from the CIO: Stay contrarian

2020 was a tough year in many respects, with all of us experiencing loss in different areas of our lives. It may have been a time of loss for investors, too, even though many market segments ended the year at levels similar to twelve months previously, with some even hitting all-time highs. Although the Covid-induced market crash was followed by a policy-driven recovery in financial markets, the trajectory was violent and, in some respects, unconventional.

Despite the challenges, the past year was also – investment-wise – a year of opportunity. For investors who understand cycles and who stayed contrarian, there were rewards. In fixed income we were able to take advantage of a beta opportunity in March, a cyclical recovery in June and the opportunity to buy into the ‘Covid-19 sector’ theme later in the year. Our clients’ portfolios benefited from these strategies.

While the impact of Covid-19 has been devastating for health, there’s good reason to believe that its effect on economies and financial markets is temporary. There are no broken sectors, the banking industry is healthy and labor markets are recovering.

But, contrary to the very optimistic scenario now being priced by the market, our view is that investors will still face some challenges in 2021. Given the starting point of financial asset valuations, the variability of outcomes in terms of market prices has increased significantly for all asset classes. And yet, only the best combination of possible outcomes is being priced by markets. The reality is that there are always surprises. At best, the year ahead could be boring, with credit markets delivering modest returns. At worst, we could be in for more bouts of volatility, surprises and weakness. In the short term, the best chance for good returns is the revival of value equity, given the broader economic recovery and a small rise in yields.

Either way, investors must stay focused on finding value, maintain an active approach and be willing to stand by their convictions. This means questioning the consensus at all times. Even more fundamentally, investors must resist the urge to build forecasts by extrapolating the most recent trends – a common behavioral bias in the industry. Instead, as has been our approach throughout our 90-year history, investment choices must be based on disciplined research and a thorough understanding of market cycles.

In addition to these cyclical forces, there is also a new secular phenomenon at work that affects all market participants: a focus on sustainability and the drive to embed climate considerations into investment results.

Robeco is fully equipped for this important secular change. We believe climate-related thinking and decarbonization are currently the most important development for the asset management industry, with the focus shifting to optimizing alpha as well as climate impact. Being prepared for these developments is critical to understanding which will be the winning sectors of the future and positioning portfolios accordingly. Our view is that the more investors take climate into account, the greater the likelihood that it will have an impact on market prices. This is also the outcome that regulators are aiming for.

Sustainability has for years been integrated into our investment practices. We invest heavily in our ESG capabilities, including access to relevant quality data, analytical tools, transparent reporting and engagement. Climate-related risks and opportunities are factored into our investment processes, and we have launched products that focus specifically on contributing to the Paris Agreement and a global decarbonization trajectory. In line with this, Robeco has announced its ambition to achieve net-zero emissions with its investments by 2050.

Our clients welcome these important changes. The sharpened focus on sustainability in 2020 confirmed this, as did the resulting inflows into our sustainable investing products, including our SDG funds and green bond fund.

This shift towards sustainable thinking is taking place against the backdrop of another critical secular phenomenon that shaped the investment landscape, namely the long-term debt super cycle. If you’re in the middle of it, it’s difficult to see a 20 to 30-year series of events with any clarity. But, for investors needing to make sound decisions, it’s vital to get to grips with these developments.

Thirty years ago, the Chinese labor supply shock caused a permanent reduction in wages, triggering the large-scale outsourcing of manufacturing activity to emerging markets. In developed markets, capital investment as a share of GDP plummeted. Also, demographic forces drove a preference for saving instead of investing, causing a savings glut. Meanwhile, overconfident central bankers pushed yields ever lower, with the aim of incentivizing economic participants to start spending and borrowing. Combined, these forces resulted in a liquidity trap and a debt super cycle. And collectively we became addicted to low yields. In this world of globalization, there has been a winner-takes-all scenario in most sectors – and tech is just one of example of this phenomenon. We have also seen capital beating labor, which has caused corporate margins to stay at elevated levels.

While overly simplified, this broadly outlines where we now are – and to some extent explains the overvaluations and the sudden and aggressive market movements. While yields had dropped continuously due to the savings surplus, and inflation was declared defeated, corporates boosted earnings per share via massive share buy backs that were funded by debt issuance. The healthier option would have been to increase investments and innovation, and to generate earnings growth from that. Instead, we have an environment in which central bank policy has resulted in yield suppression, too much liquidity, rising indebtedness and overcapacity. This overcapacity has been the consequence of creative destruction being avoided: everyone survives at zero rates, including the weak companies.

Every business cycle that played out during this massive globalization trade has been driven by growing debt and less inflation. Every cycle ended with lower yields and larger debt burdens, and with corporate optimism intact. To be fair, this optimism has been justified, more often than not, with equity markets, credit markets and even bond markets rallying.

What’s next? Much like a pendulum, there is a natural tendency for markets and economies to return to equilibrium. The question is whether we will allow markets to look for an equilibrium or whether we will continue blowing bubbles. One possible theory is that it could be policy response that shakes things up. The first response in 2020 was indeed the correct one, as the flooding of markets with liquidity and massive fiscal stimulus was critical in preventing a meltdown. But the risk now is that we go into overdrive: if the economy heals and stimulus remains as is, markets will overheat.

Another possible risk is that any reversal in the policy thrust will disrupt markets. A change in the policy direction will be a shock to markets, investors and businesses that for decades have been addicted to cheap(er) money. The danger is that such a disturbed market reaction could move policymakers to act out of fear and add even more stimulus, causing further distortions and delaying the return to equilibrium. This way the imbalances grow even further.

For now, central banks have signaled that interest rates will stay low for a long time. In the next few years, when the economy has healed but stimulus is still excessive, markets will force central bankers to show their hand. At that point, with inflationary forces afoot, it will be tough for policymakers to uphold their promises to keep rates low. Although not a forecast of ours, rising rates is nevertheless a realistic scenario. Importantly, such a scenario is not priced by markets.

When yields start to rise, markets will return to equilibrium, and excesses such as over-indebtedness and extreme mispricing will be dealt with. While we don’t know when this will be, we remain vigilant against dangerous consensus thinking and stay focused on doing our research.

Valuable tools such as machine learning, big data and artificial intelligence will help us in this process of constantly challenging our thinking and of extending our research. Our data scientists and data management systems analyze vast amounts of data, which over time will increase our understanding of our alpha skills. Technology will also help us not to fall victim to behavioral biases ourselves. It will not change the basic principles of successful investing, though. These principles will always be contrarian investing by buying low based on good analysis, and selling high based on conviction – and not on extrapolating forecasting errors. While harvesting behavioral biases will endure, the way in which this harvesting is done will change in the years ahead.

A return to stable market performance and financial returns is not a guaranteed outcome once Covid-19 has been defeated. Instead, investment success will require knowledge, research and critical thinking. And this definition of success will continue to be redefined to incorporate the broader concepts of societal well-being and sustainable outcomes. As an investment house, we are ready to deploy our expertise and experience in these areas in 2021, for the benefit of our clients.