This has been a year defined by a sweeping pandemic, collapsing economic activity, unresolved political strife and soaring equity markets. The juxtaposition is jarring. In a year when so much went so wrong, can investors be accused of willful ignorance or is theirs a wager of calculated risk?
In our professional lifetimes, spanning collectively more than a half century of engaging with financial markets, we’ve witnessed way too many examples of individual or mutual investor madness to ever assume away willful ignorance. Yet, what has unfolded in 2020 looks more like calculated risk. What should be expected for 2021?
To answer this, we must first re-cap market performance this past year and unpack how it relates to the economic and institutional factors that drive asset prices.
The deadly global pandemic that rapidly spread in the first months of 2020 had no known medical remedies nor effective vaccines. Governments and societies had only one tool to mitigate death and suffering, namely social distancing. Enforcement required economically devasting lockdowns, compounded by collapsing demand as consumers and businesses reined in spending. Economies went into free-fall, as did global equity markets.
Policy-makers responded rapidly, and in unprecedented fashion, to the economic shock. Central banks slashed interest rates to historic lows, engaged in large-scale asset purchases and expanded purchase programs (backed by US Treasury guarantees in the case of the Federal Reserve) to previously ineligible asset classes, such as private sector debt securities. Fiscal stimulus ranged from 8% of GDP in Germany to 13% in the US and over 20% in Japan. The European Union made history with supranational spending initiatives.
Never in recorded history have fiscal and monetary policy come together in such concerted and sizable fashion. As the contours of the macroeconomic policy response became clear in the second quarter of 2020, global equity, credit and bond markets soared.
And yet, despite the impressive surge of global risk assets, their initial recovery was measured. Investors realized that financial and economic collapse had been averted. They were less certain that recovery was assured. Accordingly, giant technology, growth and quality stocks did best. More cyclical stocks and sectors, such as transportation, industrial, financial, smaller capitalization or value stocks lagged, or some cases continued to fall. Some even went bankrupt.
Investors remained cognizant of risk, even as they reached for opportunity.
Indeed, it was not until late October that the cyclical laggards assumed market leadership, with sectors such as Energy, Financials and Industrials springing to life and leapfrogging styles such as Quality or Growth. Their fourth quarter surge has been driven by two fundamental changes: (i) the development and distribution of effective Covid-19 vaccines and (ii) the anticipation that a Biden Administration brings greater predictability to US public policy and geopolitical affairs.
Accordingly, as investors saw reduced cyclical, policy and political risks, they began to rotate toward companies that would most likely benefit from a brighter earnings outlook and lower risk premiums.
Calculated investor risk-taking in 2020 had one other critical dimension—faith that low inflation and low interest rates will prevail for considerably longer. As bond yields fell to historic lows earlier this year, belief in ‘lower for longer’ was reinforced by recession, enormous output gaps, soaring levels of unemployment and unprecedented easing commitments by central banks. The latter included the Fed’s revised objective to pursue inflation overshooting.
Very low interest rates super-charged the TINA-effect (‘There Is No Alternative’ to equities) that pushes investors into global stocks. Institutional factors, such as the unrelenting need for pension funds to meet unrealistic long-term return mandates, reinforced the 2020 move into global equity markets.
Which brings us to the present and the outlook for 2021. Is the calculated risk-taking that broadly characterized 2020 warranted for the year ahead?
In the near term, investor optimism may dim. Vaccine production, distribution and acceptance could easily fail to meet lofty expectations. High rates of infection are already forcing some key economies, such as California’s or New York’s, to lockdown again. The outbreak of a new, more contagious Covid-19 strain in the UK has caused the government to introduce severe social distancing measures over the holidays, and other major European nations have banned visitors from the UK. It serves as a reminder that viral mutation could undermine expectations that the pandemic will soon abate.
Politics may also disappoint. Tense, last-minute Brexit or US fiscal negotiations could fail. Hard Brexit would not just deliver economically damaging outcomes for the UK and EU, it would also remind investors that the end of Trump’s presidency does not assure a return to global political and economic harmony.
But perhaps the biggest challenge for investors awaiting in 2021 is inflation. It may not be probable – inflation expectations and transmission mechanisms have been fundamentally altered in recent decades – but if inflation does recurr, it will challenge the investment landscape unlike anything seen in the past half century. Unexpected inflation would fundamentally erode government and corporate bond valuations, and simultaneously lead to a surge in equity risk premiums. In a world where inflation causes bonds and stocks to simultaneously plunge, investors will find little refuge.
In sum, 2020 has been a year of calculated risk. But periods of strong returns often spawn complacency and excessive confidence. Pitfalls, setbacks and secular changes are easily underestimated when investors are overly confident in their ability to calculate odds and calibrate portfolios. During 2021, we won’t be surprised if the investment narrative shifts from ‘calculated’ to ‘risk’.