2020 confounded the pundits.
A wretched year of pandemic, recession and political uncertainty nevertheless delivered strong investment returns. Broad global equity indices notched up double-digit growth, while fixed income total returns were in the none-too-shabby upper single digit range. Given advanced economy inflation barely over 1%, balanced portfolios of stocks and bonds produced stellar real (inflation-adjusted) gains last year.
Economists and company analysts forecast brighter prospects in 2021. According to the International Monetary Fund, real global GDP growth will top 5% over the next twelve months. Many private sector economists are even more bullish. Flattered by easy comparisons to last year’s earnings washout and boosted by forecasts for higher business revenues, the consensus sees 22% corporate profits growth in 2021.
Should investors double-down for another good year? Or might 2021 prove the old market adage that ‘good news is bad news’?
Fundamentally, there are plenty of reasons to be hopeful, even upbeat. Worldwide, various Covid-19 vaccines have been approved or will soon be. They boast high rates of efficacy. Logistical challenges in production, distribution, allocation and acceptance remain significant, but are surmountable. It has become easier to envisage a world where the return to work, consumption and investing in the future is probable.
Economic recovery will remain supported by easy monetary and financial conditions. Central banks have promised to keep interest rates low, yield curves flat and are willing to provide vast quantities of liquidity to deliver on their pledges. In the US, 2021 starts off with another round of fiscal stimulus, even if it is more modest than some might have hoped. Nowhere are governments seriously contemplating a tightening of fiscal policies.
Political risk is likely to be lower in the coming year as well. ‘Hard Brexit’ has been avoided and while difficult negotiations follow, the urgency of meeting deadlines has faded. The UK will surely be economically worse off for its decision to leave the EU, but the pernicious consequences will be gradually corrosive, not the stuff of sudden shocks. The incoming Biden Administration faces daunting political, policy and economic challenges, but every indication is that level-headed, determined centrism will characterize their approach this year. Congressional support cannot be counted upon—obstructionism and extremism remain the by-words of the ‘modern’ Republican Party—but even stasis is unlikely to be a major concern for investors banking on receding pandemic and political risks.
Yet with all that said, investors must guard against complacency.
For one, last year’s strong advances in equity, credit and other ‘risk’ assets were largely predicated on the positive outcomes described above. Polls consistently predicted Biden’s victory. Vaccine development was widely tracked. Economic and earnings forecasts were adjusted higher already last autumn.
Optimism about the future can be seen in the prevailing one-year forward valuation for the S&P500, currently a multiple of 24 times earnings, well above its long-term average near 17 times. Good news is heavily discounted in today’s asset prices.
Moreover, as the pandemic itself reminds us, adverse shocks are never far away. The virus could mutate rapidly, slowing the rate of effective vaccination and ‘herd immunity’. A growing rapprochement between Israel, the Gulf States and Saudi Arabia, facilitated by increasing US indifference to regional stability and serving to further isolate an already isolated Iran, could spark destabilizing proxy or even hot wars in the Middle East.
But perhaps the greatest ‘endogenous’ risk facing investors is that their brimming confidence in supportive monetary policies will be questioned at some point this year. The same ‘base effects’ that will boost year-on-year corporate profits growth in 2021 will also push inflation higher. True, the Federal Reserve is committed to tolerating an inflation overshoot. And, yes, inflation in Europe and Japan remains well below official targets. But as the soaring price of Bitcoin reminds us, seeds of anxiety about monetary debasement have been sown. The degree of fiscal expansion seen in the past year, as well as following the global financial crisis a decade ago, is unprecedented in peacetime. Government indebtedness is high and climbing.
Yet, the political will to take tough decisions regarding taxes and expenditures, particularly in a world of massively skewed income and wealth, is nowhere to be found. President Biden is, by his own admission, a transitional president. Angela Merkel is headed to the exit. ‘Splendid isolation’ diminishes the already diminished stature of Boris Johnson. Emmanuel Marcon looks a largely spent force. The EU remains incapable of real forward thinking policy—its legacy since the founding of the Euro largely resides in crisis management, not crisis prevention.
Hence, the onus for macroeconomic stabilization policy rests squarely on the already burdened shoulders of central bankers. They must decide when to remove the proverbial ‘punch bowl.’ The Fed is committed to a longer binge, but will that commitment remain credible as inflation rises? Will investors have a re-think? Notably, market setbacks are often caused by the mere arrival of doubt in widely held beliefs.
In short, the key risk we see to markets in the year ahead is mistaking good outcomes for good news. The outcomes we all fervently hope to see are, for the most part, no longer ‘news’ to investors.
Simply put, a Panglossian perspective of the future is the biggest enemy of investors today.
