According to the online Merriam-Webster dictionary, “pandemic” is the most searched word of the year. COVID-19, a once-in-a-century pandemic that started in Wuhan, China, has brought the world to a halt with more than 1.79 million deaths recorded to date. The same pandemic saw buoyant markets and high inflation expectations.
This huge disconnect between Wall Street (capital markets, big business, and high net worth investors) and Main Street (average citizen, small business or real economy) will be the biggest asset for investors this year. This article examines the divergences from what investors might have expected during a pandemic and the economic realities, dynamic stock markets and high inflation.
Dynamic stock markets
How does a headline titled “Pandemic Lift Global Stock Markets to Record High” for an investor? Obscene, to say the least; Yet that was the story for 2020.
The tech-driven US stock market is over 14% higher from the same period last year, bringing the global market to around 12% higher, even though the European stock market is still around 10% higher. % below its peak in mid-February. Investors who decided to be cautious and stay away when COVID-19 erupted are no doubt curious as to why the global stock market is at an all time high as the pandemic continues to ravage the economy global.
The explanation is record bond yields!
Equity valuations rise when bond yields fall. When bond yields approach their lower limit, bond prices approach their upper limit. This means that the possibilities of a further rise in prices diminish while the possibilities of collapsing prices increase.
In short, the lower the bond yield, the lower the possibility of making a positive bond yield. As bond yields decline, the excess return on stocks over bonds, known as the equity risk premium, decreases towards zero. Logically, if the risk of equities and bonds converges, all risk premiums must disappear. Take the example of the 10-year Swiss bond: the price of the bond can hardly go up but it can fall sharply. More recently, Italian, Spanish and Portuguese 10-year yields – falling to their lowest levels on record – have left limited upside potential for bonds.
The result of falling bond yields is that the potential return, known as the “ discount rate, ” required on stocks, decreases exponentially, because the two components that make up that discount rate, bond yield and equity risk premium are positively correlated and will decline in tandem. Since the valuation is the inverse of the discount rate, the valuation of stocks increases exponentially when bond yields dip to ultra-low levels. Conversely, the valuation of stocks declines exponentially when bond yields drop from an ultra-low level.
Looking back, it seems the appropriate aphorism during the pandemic would have been: “Focus on valuations, not profits”. The dramatic shift in valuations was driven by the dramatic shift in bond yields as central banks around the world responded to the pandemic. This is hardly surprising, given that the potential return of stocks is sensitive to the potential return offered by bonds. But at very low bond yields, this sensitivity becomes hypersensitive, which drives the equity markets up.
Inflation has invariably plummeted in the early stages of the pandemic, mainly due to significant price declines in the worst affected sectors such as energy and hospitality. As restrictions began to ease, prices for these goods and services began to rebound, and this reflation was compounded by inflationary effects in other sectors.
The result has been that, despite the initial deflationary impact of the pandemic during lockdowns, inflation is already rebounding faster than normal for this early stage of the economic recovery. Because the lockdowns have caused output and spending to decline, with the latter recovering faster than the former, inventories are unusually low for this stage of the business cycle, which is putting upward pressure on goods prices. In addition, ongoing physical distancing restrictions have increased costs and reduced supply in many service sectors.
Just as globalization and the dismantling of trade barriers have exerted downward pressure on the prices of goods in recent decades, deglobalization could have the opposite effect. The pandemic could further accelerate the trend towards de-globalization that has developed in the wake of trade wars and songs of decoupling. This will inevitably worsen global shortages of some key commodities, exposing the dangers of over-reliance on imports and complex global supply chains, putting upward pressure on prices.
The pandemic has generated huge increases in public debt across the globe as countries implemented fiscal policies to help their economies stay afloat. One case that demonstrates this burden is Zambia, which has become the first African country to default on debts since the start of the pandemic, raising fears that more defaults are consuming the continent, which is heavily in debt. Knowing that there is no direct causation between higher public debt and high inflation, most governments often end up resorting to various methods of financial repression, which encourage price hikes that reduce value. real debt, ultimately inducing inflation.
In the United States, the Fed’s recent shift to some form of medium inflation target suggests that inflation compensation may rebound more strongly during the economic recovery than during past recoveries. The goal of generating inflation above 2% to offset past deficits suggests that the central bank is likely to keep its policy very loose for some time, even if real inflation starts to pick up. While across the pond in Europe, the European Central Bank has already started to consider overshooting inflation, echoing the Fed’s strategy.
Overall, beyond the short-term forecast horizon, the pandemic has left the long-term risk balance on inflation more skewed upward. In particular, a more activist monetary policy could eventually lead to a surge in inflation, not because central bankers lack the tools to contain demand, but because of pressures from politicians and society in general. so as not to use them.
Conclusion of 2020
Even though families and friends didn’t travel much for holiday gatherings this year due to lockouts, Santa still had a special way to end the year for the stock markets. At the end of 2020, we remain optimistic about the rollout of COVID-19 vaccines around the world.
Wishing every investor a prosperous 2021.
Richard Maparura, CFA, Senior Portfolio Manager, Butterfield Bank (Cayman) Limited
Disclaimer: The opinions expressed are the opinions of the author and, while believed to be reliable, may differ from the views of Butterfield Bank (Cayman) Limited. The Bank declines all responsibility for errors or actions taken on the basis of this information.