Climbing the Wall of Worry | Top Down

28 January 2021

The world is still in the grip of the Covid19 pandemic and equity markets continued to grind higher. The distressing impact of this virus had not led investors into a ‘flight to safety’. Bond markets were flat to slightly down year to date. In recent days this seems to have gone into reverse. The reason for the earlier strength was the belief that the current dislocation is temporary. The spread of the virus would decline and as vaccination ramped up we would not have to have further lockdowns and in the meantime, fiscal supports which have been put in place to maintain incomes, induce a large spurt in consumption as economies start to reopen. After a troubled start the Global Economy would rapidly get back on course. This may sound farfetched when one considers what we are going through at the moment but let us not forget that globally goods consumption exceeded the pre-Covid level last October. It is likely we will see an equally sharp rebound in services consumption once the re-opening gets under way.

Maybe it is valuation?

Equity markets have risen significantly since the lows of last March and the historic multiple sits well above long run averages. However, earnings are still very depressed and there will be a very strong recovery in 2021 which continues into 2022. That historic multiple will drop very rapidly as we travel through 2021. The story of this recession so far is that it is not as bad as was feared and the recovery was faster and stronger than expected. This is likely to continue to be the case. We are at the early stages of the Q4 results season and the indications are very good. Profit forecasts were increased going into this reporting period. This is very unusual, normally we see the bar being reset downwards so that we can have a ‘good earnings season’. This is not the case now. The bar has been reset upwards and we are beating it by a large margin. So, you can expect profits to rebound stronger than expected which will bring that historic valuation down even faster.  

And there is more policy support on the way

The result of the US elections has been a help. It has delivered a Democrat government which looks like it is going to deliver more fiscal stimulus which will give greater confidence in that economic rebound from Q2 onwards. The new President has already re-engaged with international organisations which will reduce international tensions, in particular between the US and euro area. The Congress is looking at another fiscal package following rapidly after the earlier than expected adoption of the December package. The euro area is quieter, but it is going through the ratification process for the European Recovery Plan which should start impacting on economies from the middle of the year. 

Meantime Central Banks remain very relaxed. The Fed has not changed its outlook despite one fiscal package passed in the last month and another one being mooted. Of late, the soundings from the Fed is no change to the quantitative easing (QE) programme this year and interest rates to remain on hold towards 2023.

For equity markets a growth promoting fiscal policy, which we are seeing across the globe, combined with Central Banks in accommodative mode is a powerful  combination and despite the short-term turbulence that we are going through should push them higher through 2021. For fixed income markets it is a more mixed. Accommodative Central Banks is a good thing but large deficits can be a problem.

And that is the risk for 2021

A disorderly bond market is the greatest risk to our outlook for financial markets. Yield levels are very low and real yields are well below long run averages. But the reasons for this is clear, negative interest rates in many parts of the world and the massive buying by central banks of sovereign, corporate and now even high yield bonds in some circumstances. Fixed income markets across the world are heavily distorted by this activity. Central Banks seem committed to this policy and this should provide some stability in the fixed income markets.

The other factor that could destabilise fixed income markets is a rise in inflation expectations. With accelerating growth and a large fiscal impulse this could happen. But there are some reasons to be wary of this logic. There is excess capacity in the global economy so a higher level of growth can be tolerated without generating inflation pressures. There is the ongoing disruption across many industries due to the digital economy which has got an extra boost from the impact of the Covid 19 pandemic. Lastly, the increase in inflation would have to be sustained to prompt action from the Central Banks. We will be watching developments here closely but believe that inflation is likely to remain subdued.

What do we do here?

In our annual outlook we put equities as our favoured asset class as we were at the early stages of an economic recovery and that the pace of the recovery would turn out to be stronger than was forecast at that time. We did acknowledge that there could be turbulence as Covid 19 cases started to rise again but that with a vaccine deployed, fiscal policy continuing to support incomes and Central Banks remaining supportive - there would be a strong and sustainable rebound from any wobbles in the first quarter.

What we have seen to date gives further support to that view. Economic growth forecasts have risen, it looks like we will get even more fiscal support, vaccination programmes are in motion and Central Banks have reiterated their commitment to easy policy. Near term disruption to activity looks greater but so does the extent of the rebound from that turbulence.

Equities remain our favoured asset class, the case for them is a little bit stronger than at the start of the year. The sectors with the best potential, if you can tolerate some volatility, are the ones exposed to reopening (Hotels, Travel, Leisure). They are being hit hard at the moment as the lockdowns go on longer than expected. But with pent up demand building, these sectors should see significant turnarounds when mobility restrictions get lifted.


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