2021: A hard look at financial markets

Stock markets around the world started the year quite strongly, with indices very close to record highs. Even ‘out of favour’ equity markets like Japan’s have seen strong performance recently as the Nikkei 225 index rose above 30 000 for the first time since 1990.

Financial markets performed reasonably well throughout 2020, behaving in a manner completely different from underlying economies. Starting the year, Stanlib identified the key factors that would influence investment markets. Economic growth was accelerating and, combined with low inflation, could provide solid support to financial markets. Central banks remained accommodative, which provided a strong tailwind.

What will drive share markets in 2021?

Central to the robust performance in financial markets in 2020 was liquidity, says Mark Lovett, Head of Investments at Stanlib. His view is that liquidity will remain a key feature of 2021 as well.

Liquidity, which in this instance refers to the amount of cash that governments around the world have injected into the financial system to stimulate their economies, was a prominent feature in financial markets in 2020 and continues to be important in 2021.

According to Lovett, in developed economies, monetary authorities have effectively cut interest rates to zero in response to the pandemic. “Authorities were able to cut interest rates aggressively – just as aggressively as after the 2009 financial crisis – because inflation expectations were low,” he says. There was even the threat of deflation to focus their attention.

Disconnect between markets and economies

This increase in liquidity has created what Lovett terms a disconnect between robust financial markets and economies that are experiencing genuine distress.

Other commentators have remarked on this anomaly of rising share prices against a backdrop of economic hardship, low growth and high unemployment. But Lovett adds a new perspective to the scenario.

“The Covid-19 pandemic that began in 2020 completely overshadows previous crises,” he says. “It has stimulated unprecedented policy responses and will shape economic, political and social trends for many years to come, even after vaccines have provided immunity to the virus. The effects of this one-in-200-year event are very evident.”

Low interest rates and high liquidity

Low interest rates and high liquidity remain the central themes that will support financial markets, he believes. Central banks around the globe have created cash by cutting interest rates and buying back bonds in quantitative easing programmes, while governments have added fiscal support through increased spending.

This high level of liquidity to support economies made its way quickly into financial markets. The net result was that the big fall in financial markets in March last year did not last long. “The decline in US equities lasted just a month or so,” says Lovett.

“US equity markets – followed by many others – recovered to record levels over the next two quarters. Admittedly, this performance was concentrated in specific sectors, such as technology, but the overall recovery in financial assets was still extraordinary, particularly against the backdrop of the social and economic pain that was unfolding,” says Lovett.

“Importantly, interest rates are still low and will continue to support markets for the foreseeable future, even if the effect will not be as big as it was when interest rates were first slashed aggressively.”

He notes that major central banks, particularly the US Federal Reserve (Fed) and European Central Bank (ECB), are resolute and vocal in their commitment to using 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 its target range.

“Through the word ‘average’, the Fed is clearly stating that it is comfortable with economic growth and inflation ‘running hot’ above its long-term target for a while to offset the historical period of low inflation,” says Lovett.

He also believes that fiscal spending around the world will remain high and will add to growth and liquidity, particularly after the Democrats won a majority in the US 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.”

Key indicators investors should follow

“The most important thing that investors should be watching this year will be interest rates,” says Lovett.

While interest rates cannot be cut further, as they are zero or close to zero around the world, low interest rates and other measures will continue to bolster liquidity.

“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 in many countries during lockdown,” says Lovett. He adds that the efficient deployment of vaccines is a crucial assumption in this thesis and “there will be significant country variance”.

“While stimulus is largely US- and developed markets-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,” he says.

This was visible on the JSE in the final quarter of last year when performance was very strong, despite weak economic data and further lockdowns. “This is the power of liquidity. It reminds us again of the real economy and financial market disconnect that can occur in a liquidity-fuelled environment,” according to Lovett.

Inflationary pressures cause for concern

But he warns that there are potentially two major “flies in the ointment” related to this combination of monetary and fiscal stimulus. The first is selective signs of bubbles evolving in specific part of financial markets, such as speculative IPOs, Bitcoin or the incredible rise in the Tesla valuation. These mini-bubbles are not substantive enough to undermine the broader economy but reflect the individual risks that develop in a liquidity-driven environment.

The second risk is that the combination of monetary and fiscal stimulus, together with the reopening of global economies, will result in a substantial increase in inflationary expectations.

Such an environment could force central banks to alter their stated game plans and increase interest rates against all expectations – 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 inflation increases faster or fails to stabilise at a slightly higher level? Will central banks need to recalibrate interest rates or, more likely, the level of quantitative easing?

“This could cause volatility in financial markets, even if there is no evidence of inflationary pressures at the moment,” says Lovett.

High share prices

Another concern is that equity markets are no longer cheap. Stanlib concludes that valuations are reasonably elevated, with both equities and credit markets trading at high levels relative to history, and earnings growth will need to materialise in the recovery. “This may inhibit market returns, even if there is a tailwind of ample liquidity,” warns Lovett.

In terms of market sectors, he says technology provides one of the greatest dichotomies.

One can accept the high prices of the big established stocks, the so-called Faang (Facebook, Amazon, Apple, Netflix and Google/Alphabet) shares, but a lot of other small technology shares are trading on very high ratings, given their early-stage business models. Some of the smaller new companies have interesting new business models, but they are loss-making and the route to profitability is not always clear.

“When looking at these models, it is easy to identify a few similarities with the tech bubble of the 1990s,” cautions Lovett. “I clearly remember both the over-hyped concept stocks which disappeared into the dust and the successful business models that transformed their industry, and others, over the subsequent 15 years.”

Positives outweigh the negatives

In summary, 2021 is looking as if it will be a mixed year from an economic standpoint, with improvements only really coming through in the second half or into 2020. From a market perspective, it will be a year that has some powerful tailwinds, but one that investors and financial practitioners will need to navigate carefully.

“Volatility levels may be higher than we have experienced over the last few years,” says Lovett. “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.”

Lovett also anticipates that regional and country variance in performance could be quite pronounced. Asset allocation decisions will remain crucial in multi-asset portfolios.

Brought to you by Stanlib.