Most investment professionals expect, and are trained to deal with, economic uncertainty. However, in many respects, the Covid-19 pandemic of 2020 completely overshadows previous crises.
It has stimulated unprecedented policy responses and will shape economic, political and societal trends for many years to come, even after vaccines have provided immunity to the virus. A unique aspect to this crisis has been the significant disconnect between relatively buoyant financial markets and the distress in the real economy. This disconnect has just added to the surreal atmosphere in 2020’s extraordinary year.
The power of injecting liquidity
Why has this disconnect occurred between financial markets and the underlying economy? The simple answer is liquidity (cash).
Monetary authorities have created cash and pumped it into the global financial system, both directly and indirectly. It has ultimately morphed into asset price inflation, including in financial markets. In a playbook reminiscent of the Global Financial Crisis, authorities responded to the Covid-19 pandemic with substantial and sustained support, delivered incredibly quickly and in a co-ordinated manner. Interest rates were cut aggressively, fiscal support packages initiated and further supplementary monetary initiatives stepped up, including quantitative easing (QE).
Although it was initially targeted at stabilising the economy, such liquidity seeped very quickly into financial markets. The net result was a very short Covid-19-induced financial markets decline – peak to trough in the S&P500 was just one month – before US equity markets recovered to record levels over the subsequent two quarters. Admittedly, this performance was concentrated in specific sectors, including technology, but the overall recovery in financial assets was still extraordinary, particularly against the backdrop of the social and economic pain that was unfolding.
2021: A cocktail of similarities and differences
In many respects the underlying trends for 2021 look similar. Monetary and fiscal stimulus will remain in place throughout this year to offset the dire outlook for businesses and economies around the world.
Major central banks, notably the US Federal Reserve (Fed) and European Central Bank (ECB), are resolute and vocal in their commitment to use all the tools at their disposal to support economies. The Fed has been the most precise in its commentary, with a forward-looking statement that policy will remain accommodative until average US inflation rates move back to target. Through the word “average”, the Fed is clearly stating that it is comfortable with economic growth and inflation “running hot” and above its long-term target for a period of time, to offset the historical period of inflation undershoot. If it is delivered, this will have positive implications for US economic growth levels and liquidity in the financial market system.
Fiscal expansion around the world will add to this growth and liquidity momentum, particularly after the Democrats won a majority (via casting vote) in the Senate. With their control over both Houses of Congress, there is an expectation that the Democrats will be able to implement their more aggressive fiscal expansion plans.
In the second half of 2021, we could very easily see a heady economic cocktail of monetary stimuli, fiscal expansion and strong consumer spending. The latter would be stimulated by vaccine deployment and pent-up consumer spending, aided by personal savings rates that have risen during lockdown. It should be noted that efficient deployment of the vaccines is a crucial factor in this thesis and there will be significant country variance on this issue.
While the stimuli commentary is US-orientated, it has important connotations for global financial markets. The injections of liquidity into the financial system reverberate around the world, including in SA, as this money needs to find an investment home. This was visible in the South African equity market in the final quarter of the year, when performance was very strong, despite weak economic data and further virus-related lockdowns. This is the power of liquidity. It reminds us again of the real economy vs financial markets disconnect that can occur in a liquidity-fuelled environment.
So what else to expect in 2021?
As we mentioned, 2021 will have some similarities with 2020 but also potentially significant differences. From an economic standpoint, it is already accepted that the first half of the year will be tough – not just in SA but across the world, excluding China.
However, the second half of 2021 could see an improved economic environment, as the deployment of vaccines would allow life to return to some form of normality. For financial markets, this comforting environment of stimulus, liquidity and economic recovery would in theory drive returns. But there are potentially two major “flies in the ointment”.
Firstly, this combination of monetary and fiscal stimuli with liquidity injections could create inflationary pressures in the system. Such an environment could force central banks to alter their stated game plans, with implications for financial markets.
From a technical standpoint, inflation is expected to pick up in the first half of the year and then stabilise – but what if the inflation pick up is faster or fails to reach a plateau? Will central banks need to recalibrate interest rates or, more likely, the level of quantitative easing? This could cause volatility in financial markets similar to the “taper tantrums” in 2016 when the market reacted negatively to the Fed’s desire to move back to a more sustainable level of monetary stimulus.
At the moment there is no evidence of inflationary pressures in the system – in reality, the opposite is true. But the concern cannot be dismissed and it is being expressed in particular financial instruments. For example, US TIPS and Bitcoin were very strong performing asset classes in 2020, reflecting some desire to hedge future inflationary risks. Bitcoin’s rise was also predicated on concerns about the credibility of monetary policy and its function as a digital alternative to gold.
Secondly, valuations are not cheap, and particularly not at this stage of an economic cycle. Equities and credit markets are trading at high valuation levels relative to history and this may inhibit market returns, even if there is a liquidity tailwind.
Current outlook: positives outweigh negatives
In summary, 2021 is looking as if it will be a challenging year from an economic standpoint and one that financial practitioners will need to navigate carefully. Volatility levels may be higher than we have experienced over the last few years. There are some financial market tailwinds that will typically keep people invested in markets, but the risks are high if unanticipated policy action is required or the virus takes another turn for the worse.
At the moment, the positives for 2021 seem to outweigh the negatives, although we anticipate greater regional and country variance in performance relative to 2020.