John Gorlow
| Dec 16, 2020
Global markets staged one of their biggest rallies in years in November, propelled by progress on coronavirus vaccines and investor relief over the end of a polarizing US presidential election. A wide range of stocks fueled the run-up, expanding support beyond the few dominant technology companies that drove up indexes earlier this year. Better than expected corporate earnings across multiple sectors added to the surge. With nearly all S&P 500 companies reporting, analysts are projecting third quarter profits fell -5% from a year earlier, which is a marked improvement from the -20% decline forecast at the end of September.
The downtrodden Energy and Financial sectors are prime examples of out-of-favor groups that jumped by double digits in November. The S&P 500’s energy sector, depressed by low oil prices and economic slowdown, ended October down more than 50% for the year. The group then bounced 27% in November alone, its best month since April, mirroring the more than 25% gain in benchmark American crude oil prices. Financials, which have lagged behind the broad market as low interest rates hurt the banking business, gained 17%, notching their best month since April 2009. The technology sector is the year’s top performing group, but barely beat the market in November, while mega-cap growth stocks Apple, Amazon and Microsoft lagged. Companies in industries such as travel and hospitality that had been hammered by the virus were some of November’s best performers. Carnival climbed more than 40%.
Overall, the S&P 500 returned 10.95% in November, its best monthly showing since April and the fourth-best month for the index in 30 years. The Dow Jones Industrial Average, meanwhile, rose 12%, topping 30,000 for the first time, and marking its best month since January 1987. The market broadening wasn’t limited to shares of large companies. The Russell 2000 index of small capitalization stocks, which is more heavily reliant on the outlook for growth in the American domestic economy, climbed more than 18% in November. The swing in sentiment was huge. Monday, November 9, was especially notable. Growth stocks (VONG) dropped -1.7%, while value stocks (VONV) roared ahead 4.25%, a swing of nearly 6%. This was the largest single-day difference between growth and value on record. If the reopening of the world economy continues, a global rotation into value might continue too. Foreign markets also staged a powerful rally. Prompted by the dollar's weakness, the MSCI All Country World Ex-US broad market index returned 13.45%, reversing last month’s decline, and outperforming the broad US market. This was its best showing since April 2009.
Optimism Despite a Viral Surge
While analysts expect the surge in the virus to threaten economic activity like consumer spending and travel over the next few months, they believe the downturn will be short-lived. On the other side of this potential dent to economic activity awaits what many believe will be potent economic stimulators, including a vaccine, further fiscal stimulus, pent-up consumer demand for services, and a surge in consumer confidence as the economy reopens.
Investors have good reasons for optimism. Sentiment has flipped from bearish to bullish, and the fear that dominated in March has given way to greed. In the United States, hospitals began receiving shipments of the first coronavirus vaccine this week (Dec 14). The economy is improving, and money has never been cheaper. Even the junkiest of junk bonds are priced for a decent rebound. US corporate bonds rated CCC offer a yield pickup above safe Treasuries that is lower than before the pandemic. Many investors believe that most companies that will fail have already done so.
Still, the situation is a study in sharp contrasts. Stock valuations have risen to historically extreme levels under the Trump presidency. The S&P 500 has an average price-to-reported-earnings ratio above 30 times, against a historical average level of closer to 20 times. With shares of Doordash and Airbnb soaring a respective 86% and 113% over their IPO prices on the first day of trading, some say it’s like 1999 all over again.
At the same time, the US economy is still struggling. The job market is weak, and both the public and private sectors are buried in record levels of pandemic-driven debt. The imminent expiration of policy safety nets in the US points to yet more unemployment along with an unknown number of corporate defaults in 2021. This story is repeated throughout the developed world.
What’s different from the dot-com bubble era is the current monetary backdrop. Back then, the federal reserve was steadily tightening its policy, in contrast to today’s super accommodative stance. Beginning with the precipitous market drop in mid-March, equities have been driven by heavily expansionary fiscal and monetary policies. Today short-term interest rates are pegged at near-zero percent, and the Fed has pumped some $120 billion per month into the financial system with its security purchases. While all signs point to an economic rebound in 2021, there’s one important issue to consider.
Inflationary Scenarios
“Investors should recognize that a market that is substantially driven by policy is often storing up future trouble,” warns the Financial Times (John Plender, 27-Nov). “This is certainly the case here because the ultra-low interest rates resulting from the central banks’ asset-buying programs have unhinged the normal relationship between risk and reward.”
Because ultra-low interest rates have provided a strong incentive to borrow by taking the pain out of debt servicing, the result has been what the FT calls “an extraordinary debt binge.” The Institute of International Finance expects global debt to rise more than $20 trillion from 2019 levels, reaching $277 trillion by the end of the year. That’s equivalent to 365% of global GDP.
This could be a problem, “because accumulation of debt appears to have a diminishing ability to generate growth.” Earlier this month Gita Gopinath, chief economist of the IMF, wrote in the FT that we are in a “global liquidity trap.” That is, interest rates are so low that households and companies hoard cash. When that happens, monetary stimulus ceases to have much impact on the price level. Hence many central bankers are calling for fiscal policy to take up more of the burden in addressing the pandemic. Yet in the US, plans for further fiscal expansion are gridlocked on Capitol Hill (though that could change shortly).
Without the central bank’s intervention in the aftermath of the Great Financial Crisis of 2007 - 2008, a global depression would have been inevitable. The snag today is that the world is increasingly vulnerable to inflation, because central banks will be reluctant to destabilize the economy and financial system by raising interest rates when debt is at such high, unprecedented levels. Nonetheless, a key theme for 2021 could be a sharp steepening of the yield curve which charts the difference in short-term and long-term interest rates, amid concern that long-dormant inflation risks could return. This explains why so many investors are bearish on the dollar, the global reserve currency. A weaker dollar in turn boosts commodity prices, an important driver of inflation expectations, and raises the cost of imported goods for US consumers and companies.
Experts say the only way to justify the current level of domestic stock prices is if one expects a strong but inflation-free economic rebound in 2021 and beyond. That may not happen. The Economist recently highlighted the views of a vocal band of dissenters who believe the pandemic could usher in higher inflation. While many disagree, the views of these “inflasionistas” are worth hearing.
We are already seeing rising valuations and prices. Stock prices are soaring. A surge in home buying spurred by record low mortgage-interest rates has sent residential real estate prices to record highs. Gold prices are elevated. And the global economy is showing signs of bottlenecks that could drive prices higher as pent-up demand is released.
While these trends are in full force at the moment, and will probably continue, others argue that the damage inflicted by the pandemic means restoring full levels of employment will take several years. Before the pandemic, even an ultra-tight job market could not jolt prices upwards. And now armies of people are unemployed. And there are other secular forces to reckon with: aging populations, innovative technology and the global sourcing of labor and capital are undeniably deflationary forces that are not expected to fade away. Further, many economists think the West, and especially the euro zone, is heading the way of Japan, which fell into deflation in the 1990s and has since struggled to lift prices much above zero.
But even a small probability of having to deal with a sustained period of inflation is worrying because the stock of private debt is so large and central bank balance sheets are so swollen. The world should be able to manage a temporary burst of inflation, but the idea that more persistent price pressure will emerge as structural disinflationary forces go into reverse is alarming.
A temporary rebound in inflation next year is possible and might even be a welcoming sign that economies are recovering from the pandemic. But as The Economist and others have noted, if central banks had to raise interest rates to keep the economy from getting out of hand, the consequences would be more serious. Markets would tumble and indebted firms would falter. Then the full cost of vastly expanded balance sheets—both government debts and central bank liabilities—would be painfully apparent.
Equities and credit valuations are irrefutably rich. In the short term, the markets will toss and turn in response to coronavirus and vaccine news. With portfolio managers’ cash holdings now back down to pre-coronavirus levels, according to the Bank of America, a wobbly period may be ahead of us. But long-term investors should stay the course. News on fiscal policy will probably improve, and a recovery is undoubtedly coming. What could appear as a potential risk for investors with shorter horizons can be mitigated by shifting portfolios now to embrace a less unbalanced vision of the future.
It’s good to remind ourselves that any economic issues we grapple with in 2021 are likely to be less challenging than the roller coaster ride of 2020.
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Regards,
John Gorlow
President
Cardiff Park Advisors
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