IN A QUICK CHANGE World, the investment bankers of Wall Street and the City of London adhered to certain rituals. One of them is the annual “Outlook”, which describes the path the economy and financial markets could take in the coming year. These extensive documents appear in the inboxes a few weeks before the end of the year.
In mid-November a strategist at a bank had just satisfied his outlook. His call for stocks for 2021 was “constructive”: Wall Street spoke for “bullish but not pointless”. But a few days later he was a little less pleased with himself. His outlook was not unmistakable. Rival strategists were also constructive.
It’s not hard to see why. The end of the Covid-19 pandemic is in sight. The governments of the rich world are rediscovering the joys of fiscal pump priming. Real interest rates are so low that sky-high stocks look cheap (see Buttonwood). In short, conditions seem ripe for further stock market gains. So mature, in fact, that a persistent thought keeps popping up in the minds of strategists. What’s going to keep stock prices from getting really crazy around the world?
Several things could prevent the market from collapsing. One is the economy. Since April, the markets have been looking beyond the damage from Covid-19 to the post-pandemic recovery. The discovery of viable vaccines seemed to bring this world closer. The economic indicators for America and China towards the end of 2020 were surprisingly strong. But the pandemic is not going smoothly. More virulent strains of Covid-19 have imposed stricter bans in parts of Europe. The damage to the global economy is likely to last longer than hoped.
Another obstacle is the bullish sentiment. According to a monthly Bank of America survey in December, the last time fund managers were so optimistic about headroom for stock market gains was January 2018. A large majority believe the global economy is in the “early cycle” phase (ie that a long growth path is ahead). Paradoxically, positive sentiment is often viewed as a cause for caution and investors have outdone themselves. Indeed, 2018 started with a lot of talk of a market collapse but ended with heavy losses in the equity markets.
Much of the current optimism rests on the idea that politics will continue to support the economy. What if policy makers change direction? Continued financial support requires political action and consent that cannot always be relied on. A natural problem is that the incentive could be abruptly withdrawn as it did after 2010. So far, however, there is little evidence of this. In America, the $ 900 billion tax package passed after Christmas adds two percentage points GDP Economists at JPMorgan Chase, a bank, expect growth in 2021. The loss of the Republican majority in the Senate could open the door to further easing of public finances. In Europe, the recovery fund of EUR 750 billion (USD 920 billion) should be felt from the middle of the year.
Another risk that keeps some bulls awake at night is resurgent inflation. Lockdowns and tax transfers have created additional savings and huge pent-up demand for consumers in the rich world – fuel for a post-pandemic shopping spree. Meanwhile, the recession has also reduced supply capacity: many small businesses (and some large ones) have perished. With enough shortages, an increase in spending could boost inflation. Such a dynamic has taken place in the raw material markets: a revival in industrial demand (especially from China) for copper and iron ore has encountered supply restrictions and has led to a rise in prices.
A temporary surge in inflation seems plausible. A sustained burst of higher inflation – and one forcing central banks to suddenly hike interest rates – seems less likely. Nor is it obvious that bond markets will react so violently that they will fatally undermine stock prices. Bond yields have been rising for months: this week, ten-year government bond yields exceeded 1% for the first time since March 2020. This increase reflects higher market expectations for inflation, which in America is now above 2%. The returns on inflation-linked government bonds, however, have hardly changed – and these real returns are the yardstick for valuing the stock markets. If the pattern of slightly above-target inflation expectations, a relaxed Federal Reserve, and stable real yields remain intact, it can certainly boost stock prices, not slow them down.
There are other hangover effects of the pandemic to consider. A big one is the debt. The companies borrowed heavily to ensure they had enough cash to withstand the lost revenue from lockdowns. The increased debt burden will weigh on companies’ finances and could in turn weigh on stock prices. But it can’t be a heavy weight. The central bank’s purchase of corporate bonds has kept the cost of financing remarkably low for companies with access to wholesale capital markets: only consider the cost of borrowing for companies rated debt BBB, the riskiest investment grade rating. The spread over government bonds is about as narrow as it was in 2006, when general credit conditions were dangerously simple. Such low borrowing costs make sustainability easier. A related concern is that the explosion in public debt will ultimately drive real interest rates higher. However, the demand for liquid safe assets tends to remain high after crises. Among these are primarily government bonds.
On closer inspection, many of the barriers to the stock market’s uptrend don’t seem that formidable. A terrible year for the economy was still positive returns on many stock markets. The fact that the recession hurt small unlisted companies more than it did large publicly-traded companies is part of the story. The other problem is the lack of returns on bonds. On a note this week, Jeremy Grantham, co-founder of GMO, a money manager, argues that stocks have already gone too far in America. “My best guess as to how long this bubble could survive the longest is in late spring or early summer,” he writes, advising people to seek refuge in cheap emerging market stocks.
Mr Grantham’s note is worth reading. But one thought remains. The case of owning stocks at these prices depends on low interest rates. This is a global condition. Why shouldn’t stock prices melt elsewhere? Perhaps Wall Street’s annual reports for 2022 will examine the wreckage of an American stock market failure. But it seems plausible that strategists will fuel prices from higher peaks – constructively, of course. ■
This article appeared in the Finance & Economics section of the print edition under the heading “Melting up”