With only a few days left we can say without any sense of exaggeration that 2020 has turned out to be a year like no other. Those of us whose experience suggested that health scares, such as SARS and bird flu, were minor events unlikely to impact economic activity, growth or corporate profits, were given a harsh lesson in the frailty of the world economy in the face of a genuine global health emergency. The virus has impacted everyone, everywhere – with economies and financial markets breaking a series of unwelcome records: the most rapid decline in activity on record, the worst month in stock markets since 2008, the worst day for equities since 1987 and so on. More recently, and to the bemusement of many, further records are now being made in the opposite direction. Amid what the FT termed ‘an almost everything rally,’ November turned out to be the strongest month on record for global equity markets. In this note we offer our explanation for the everything rally, consider who eventually foots the bill for the pandemic and what 2021 might bring for investors.
According to the IMF, the world economy will have shrunk by 4.4% in 2020. This is a far greater decline than ever before recorded. Following on from that, data group FactSet forecasts that US corporate earnings in 2020 will decline by c14%. To reflect this setback and the doubts about when, or even if, earnings rebound, the S&P 500 index of US equities was down, at worst, by more than 30%. This seems reasonable to us – even if there is no way of gauging whether the size of the adjustment is appropriate. What is less easy to rationalise is the subsequent bounce. From a low on 25 March, the S&P 500 index has recovered by a thumping 65% to the time of writing, leaving the index some 14% higher than at the start of the year. And it’s not just the US, the MSCI All Companies World Index (ACWI), a broad measure of equity prices across 23 developed and 27 emerging markets, rose by 12% in November alone, and now also stands at an all time high. The global economy shrinking by 4.5%, whole sectors of business activity no longer viable, earnings down, dividends cut – and shares prices up. Go figure.
The explanation, in our view, lies in the price of that singularly important commodity, money. Interest rates in the developed world are effectively zero, and central banks have promised to keep them there for some time. The ‘price’ of money is zero, and, as that is evidently not sufficient for the central bankers, the ‘quantity’ of money is being boosted too. So, if you have money in the bank, the return on it is, pretty much, zero. Coupled to that (provided you have a strong credit rating) the cost of borrowing is pretty much zero. In these circumstances, it makes sense to borrow and buy ‘almost everything’. It is against this backdrop that equity markets are hitting a series of highs and corporate and non-investment grade bond prices have recovered fully. Even in Brexit-battered Britain house prices, according to Nationwide, are 6.5% higher than they were 12 months ago and are rising at their fastest pace in six years.
The connection between the damage inflicted on the world economy by the pandemic and rising asset prices is, of course, the desire of the authorities to ward off a steep and prolonged decline in economic activity, or more importantly the resulting rise in unemployment, along with the misery and possible social unrest that comes with it. The truth of the matter is that developed world governments now take responsibility for employment and general economic welfare – albeit to somewhat differing degrees. So, when a pandemic hits – much as when a global financial crisis hit in 2008 – the monetary and fiscal fire hoses are turned on full in an attempt to dampen the damage. In all this, asset prices are a side show and, to stretch the fire hose metaphor further, when the water is full on, everything gets wet. Some of the largesse of the authorities finds its way into asset prices. Do the authorities care about runaway asset prices? Not much. They’d rather they went up than down – because of the positive impact of wealth effects, but they are absolutely a side show compared to keeping businesses afloat and people in work. Within this framework, rising asset prices make sense.
Before moving onto the outlook, we should consider the reckoning – who eventually pays for the government’s largesse, the job retention scheme, the income support scheme, the business interruption scheme and the bounce back loans, among others? The accepted wisdom, of course, is that taxes must rise. It all comes back to the poor old taxpayer in the end. Earlier this week, the FT reported on a piece of research from Warwick University suggesting that a 5% tax on all wealth above £500,000 would raise a handy £260bn to help fill the UK’s ‘financial gap’. Interesting idea? Not really. The Victorian era is long in the past and we’ve known for the best part of a century that Mr Micawber’s advice on balancing the books is entirely unhelpful when applied to whole economies. Sucking cash equivalent to 10% of GDP out of the economy would be disastrous for consumer spending, confidence, business sentiment and thereby unemployment. More interesting, to us, was the FT article discussing the possibility of the ECB cancelling some government debt in response to the additional €1.5tn of borrowing taken on by European governments to address the economic consequences of the pandemic. To be fair, the idea garnered little support from the cast of experts consulted, with the chief economist of Berenberg calling it, ‘the worst idea of the year’. However, there seemed much more support for a programme of swapping the debt into zero interest, perpetual bonds (that is, bonds that are never redeemed). One approach is the equivalent of tearing up a piece of paper, the other that of locking the piece of paper in a filing cabinet, forever.
So much for 2020. On the eve of 2021 things look more promising. We have the promise of a miracle cure for all of 2020‘s ills, in the shape of highly effective vaccines. Economies will be able to gradually reopen, businesses can begin re-hiring and corporate earnings can recover (FactSet has 21% growth for S&P 500 companies pencilled in for 2021). With the monetary, and fiscal hoses (in terms of low rates and government spending), still fully open, why should 2021 not see a continuation of growth in asset prices? This is what investors are starting to sense now.
For now, we find ourselves agreeing with this view of the world. However, the frustrating thing about stock markets is that they tend very quickly to price in the consensus, leaving investors watching for the next twist in the road. In particular, we are looking out for three possible developments that could upset the bullish bandwagon as the new year unfolds. Firstly, there may be a realisation that vaccine-driven optimism is premature – given that the infection numbers are still rising in many regions and the economic impact of ‘lockdown 2’ is only now making itself felt. Secondly, there is the risk that we are wrong on inflation, and it starts accelerating much more rapidly than currently expected. In this scenario, bond markets would start to re-price very quickly, followed by equities. Finally, there is the possibility that investors arrive at the view that, even if the growth in 2021 looks attractive, it is nothing more than a recovery of the earnings lost this year – and doesn’t warrant any further expansion of valuations. Or to put it another way, perhaps 2021’s good news is already fully priced in. Should we see evidence of any of these, or indeed anything else that might warrant a review of our current positioning, we will of course be in touch.
