By Stephen Jones
The most significant scheduled political event
in advanced economies is the US presidential election and last November’s election
over-delivered on drama.
Over the past six months when it looked as though Trump might prevail, equity markets rallied – more of the same for them would do just fine. Then when Biden won with, what looked like a split Congress, equity markets rallied – the more rabid ambitions of the more extreme Democrats would be thwarted. Finally, when the Democrats emerged with outright control, guess what – equity markets rallied (on fewer obstacles to more generous fiscal support).
Throughout all this, and for equity markets, “the only way is up”!
The support for stronger equity markets has been clear. We are living though a Covid-induced demand suppression, not depression.
When freedom of movement is fully restored, the release of pent-up demand should boost corporate earnings. Cash remains, and it seems will for years remain, available in infinite supply and almost free – and it needs to go somewhere.
The longer-term cost of capital for companies has collapsed from the spike seen last spring – the excess yield in lower grade corporate bonds has slid from eleven per cent to just 3%. While this could drive complacency, measures of implied equity risk evidence a lingering caution. There is still a wall of worry to climb.
It is the nature of equity investors to quickly forget past problems. With some forecasters looking for the US economy to balloon by 6% this year – with everywhere else hanging onto the coat-tails– it matters not that this is, in large part, the reflex reaction to an unprecedented, post-War slump. A surge like this would usually be keeping central bankers awake at night and would see bond investors running for cover, but not this time. The US Federal Reserve has dialled down its reaction function, prepared to tolerate the occasional spike in inflation and, along with all other central banks, is happy to buy enormous quantities of debt, regardless of the yield.
Standing back, it is not hard to understand why. The global economy has been decelerating for many years; fine when the policy target was lower inflation, but not so fine when that same low inflation became the problem. Central banks, the world over, have tried every trick in the book to deliver higher nominal economic growth and failed; now Governments have been compelled to get the chequebook out. If we are ever going to create the wealth sufficient to honour the debts that collectively we have taken on, then this is probably the last throw of the dice. Opportunistic deflation was the policy mantra from 1982 – keeping policy tight for just that little bit longer to lock-in a lower inflation rate before engaging in cyclical easing; we are now in the era of opportunistic reflation. The over-zealous pursuit of stable prices however ended badly and the pursuit of faster economy will probably not end any better.
This rosy outlook – helped by the EU/UK trade deal, the imminent departure of the erratic leader of the Free World and the necessity to throw money at climate change, is fuelling a powerful rotation in everything that has lagged in recent years and particularly so, last year; US exceptionalism isn’t quite as stark as it was.
If this continues – and as said policymakers are not, as in 2000, going to stand in its way, then the recovery in these stocks could be significant. Turkish equities could double and still be below the average level of the pre-Covid years, doubling would be a modest target for so-called Value stocks and the cruise company Carnival would need to quadruple to be higher than it was in February.
A surge in the real economy could breathe life into energy stocks – which have all but vanished from major equity indices. This would be a classic “pain trade” that challenges the many institutional investors who – in the face of immense stakeholder pressure – have used exclusion (of oil and gas companies) as an easy way to boost their green credentials. This was win-win when oil stocks were under-performing – “look, we went green and outperformed”. They won’t look so smart when “dirty” stocks start to fly. The conditions for a “dirty” rally are in place: (much) stronger final demand and dented supply after years of under-investment.
2020 was challenging in many ways. With investors hoping for easier times, 2021 may eventually disappoint. We may not suffer an exogenous shock again, but the endogenous pressures could still be strong and historically they have been bad enough.
When sentiment sours – as it will, we have seen in recent years, that only cash is really king and yet cash, is, by design, an expensive asset.
Given that we cannot all switch into cash without suffering painful losses, elevated measures of market risk may not be as anomalous as they might seem. A major hiccup doesn’t however seem an early threat in 2021.
Until it comes, we might as well party!
Stephen Jones is chief executive officer at Aegon Asset Management UK.
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