One of my must-reads each week is The Economist.
I love their common sense and rational approach to explaining the pros and cons of each situation, whether that’s global politics, the economy or markets.
In this weeks’ edition, there’s an articled headed ‘Melting up’ which looks at the factors that could drive stock market performance even higher in 2021.
With global markets already flirting with record highs and setting new records in some cases, what’s the likelihood that equities could keep on with their upwards march this year? More to the point, what are the issues that could derail market progress in 2021?
I’m going to take a look at a few of my favourite lines in the article and share my thoughts on how likely these are to materialise.
The article starts by looking at the ‘fiscal pump-priming’ that’s taking place.
We’ve broadly got a couple of things happening at an international level right now. We’ve got monetary easing, which is the central banks printing money and keeping interest rates incredibly low. And then we’ve got fiscal easing, which is the government spending money on different things, including grants for businesses, the self-employed and furloughed staff.
There’s a huge amount of money flooding the system, and it’s one factor that could explain why stock valuations are so incredibly high at the moment. When we look at the challenges faced by the economy, here and around the world, the recession seems at odds with the stock markets marching on. There’s a serious disconnect between the two.
The Economist article refers to real interest rates being so low as to make sky-high stocks look cheap. I’ve referenced this factor in a previous video, where I talked about how low-interest rates are used to discount the future profits of companies, and therefore allow for these very high valuations.
In a world where we expect interest rates to remain low for a long-time, that explanation seems to support a continued high for equity prices.
They then ask the question, which is apparently on the minds of strategists, “What is to stop stock prices worldwide going on a really crazy run?”
The first factor is the economy.
The article notes that markets have managed to look beyond the economic damage caused by Covid, since March, and look ahead to the post-pandemic recovery. That’s the disconnect between the markets and economy I mentioned earlier.
Is it still the case that economic recovery is just around the corner?
I know we’ve got the vaccine now being rolled out, with the third one, the Moderna vaccine, being granted regulatory approval in the UK yesterday. But it’s going to take some time. And new variants of the virus, the UK variant and the South African variant appear to be driving the latest wave of infections around the world.
While there was cause for optimism about the speed of economic recovery towards the latter part of last year, I think we’re starting 2021 in a less optimistic way. Or at least a more realistic way.
The second barrier to a market melt-up in 2021 is bullish sentiment.
According to the article, investment funds managers haven’t been this bullish about equity markets since January 2018, that’s based on a monthly survey from Bank of America in December. A large majority of fund managers think the global economy is in the early cycle phase, which means there could be years of growth ahead.
But, as the article rightly points out, overly bullish sentiment is often a reason to be wary. There’s that great quote from Warren Buffett; it is wise for investors to be “fearful when others are greedy, and greedy when others are fearful.” Looking back to the start of 2018, the last time investors were so optimistic, and the year ended with heavy stock market losses.
The Economist explains that much the current levels of optimism rely on the belief that monetary and fiscal policies will continue to support the economy. But what if that support is withdrawn? They refer back to 2010 when stimulus was withdrawn abruptly.
There are a few factors acting in favour of continued monetary stimulus; in the UK, the Bank of England has confirmed its asset purchase programme at current levels running through until September. And in the US, the $900 billion fiscal stimuli was only passed a little over a week ago and is expected to add 2% to the American economy this year.
Another risk to a market melt-up in 2021 is resurgent inflation. I’ve made a video about this recently, which I’ll link to up here somewhere, asking whether hyperinflation is a risk this year. But even a modest resurgence in price inflation could pose a risk to markets.
Once this pandemic is over, in the sense that we’re allowed to go out shopping, eating and holidaying again, there’s going to be a spending spree. I think that’s pretty much accepted. For everyone who has been sitting at home since March, not spending money and instead paying off debt or squirrelling it away in savings, it’s going to be the mother of all spending sprees. And that higher level of demand could drive up price inflation.
If that bout of price inflation is temporary, it’s not too much of a concern. But what happens if it’s sustained. In that scenario, central banks could be forced to hike interest rates, and that could seriously damage equity valuations. While low-interest rates today make stock valuations look, well, not cheap but not overly expensive, a rise in interest rates could change that picture very quickly.
The Economist notes that bond yields have been edging up for months.
The 10-year Treasury yield in the US went north of 1% this week, for the first time since last March. Markets are expecting rising inflation; still at modest rates.
But inflation-linked Treasury yields are more or less static, and it’s these real yields that are used as a benchmark for stock market valuations. So once again, probably not too much to worry about there.
Another risk factor explained in the article is debt.
We know the government is borrowing a huge amount to spend on its coronavirus relief efforts, and businesses borrowed a lot of money too. Higher debt levels will act as a drag on profitability and that could feed through into equity market valuations this year. But according to The Economist, that’s unlikely to be a heavy drag on prices.
So, in conclusion, these various obstacles to a stock market melt-up in 2021 don’t appear to too significant. We’ve just seen, in 2020, that we don’t need a good year for the global economy to experience a great year for the global stock market.
As long as interest rates remain low, there seems to be a strong case for owning stocks. In fact, and moving away from the article now to more of my own views on this, there’s always a strong case for owning stocks. Over the longer term, equities outperform other investment types.
The key to success with investing is taking the long-term view, and accepting that volatility occurs in the short-term. The up and down movements in equity markets is the price you pay for the longer-term returns.
It’s this experience of owning equities which makes our behaviour as investors such a key determinant of success or failure.
If we panic when equity markets wobble, as they often do, and we take money off the table at that time, we can easily get sucked into the sell low, buy high trap. Repeat that a few times and the performance of your portfolio will be miserable.
Instead, ignore the market movements.
Assuming you’ve got a well-diversified portfolio, with diversification not only across the mainstream investment asset classes, but also within your equity component; don’t rely too much, for example, on a handful of the largest companies in the world, or only tech stocks.
Assuming you’re willing and able to ride out short-term volatility to enjoy the long-term rewards. Then equities can and should be a central part of your investment portfolio.
I quoted Warren Buffett earlier in this video, so here’s another of his quotes to leave you with; It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
Stick to buying wonderful companies and try not to worry too much about only buying them at wonderful prices.
What’s your favourite Warren Buffett quote?