The outlook for markets in 2021 among investors and analysts is easy to describe: cautious optimism.
Almost universally, fund managers believe the year will bring a rebound in economic activity, supporting assets that have already soared in value since the depths of the pandemic crisis in March, but also lifting sectors that had been left behind. Bond yields are expected to stay low, lending further support to stock valuations.
But the virus mutation found in the UK, which caused a brief wobble in markets late this month, highlights how it is not always smooth sailing.
We asked investors: what can go wrong?
The answers below have been edited for clarity and length.
Rising interest rates, unlikely as they are in the intermediate term, are the main threat.
Today’s high asset prices are highly dependent on low interest rates for their appropriateness. If rates were to rise, asset prices would probably fall. However, there’s little reason to believe rates will rise in the short run because there doesn’t seem to be much inflation, and I believe the Federal Reserve isn’t concerned about inflation.
I don’t think central banks will have to look through inflation, because I don't think there will be any. If I’m wrong and it does accelerate, that’s a meaningful game-changer for markets.
It would mean that a lot of losers in markets that have been left behind could really catch up — think of banks and financials, but also the broader value factor that has suffered secular underperformance over the past decade. Growth stocks would suffer from rising interest rates. They might still rise but less than value. And obviously government bonds would suffer.
Everybody has the same benign outlook. That’s also a risk. We will be monitoring closely to see any concerning concentration in positions.
Fixed income investors face two key risks entering 2021.
First, the extraordinary Covid-19 policy response has extended the challenge of low yields. Second, central banks have limited policy ammunition in the event of a negative growth shock. This backdrop sharpens our focus on constructing balanced portfolios that are resilient to bouts of market volatility.
The recent market rally is based on blind faith in the vaccine and on the brave assumption that very soon, everything will revert to as it was before, or even better. This is a risk: producing and distributing these vaccines on such a large scale won’t be a walk in the park.
Fiscal and monetary support are keeping economies afloat, but only just. These measures are getting harder to implement. Expect more monetisation of debt and increased pressure on central banks — any withdrawal of measures is unthinkable right now, and the risk of a policy mistake is underestimated by the market.
The third risk is the consensus itself. The hunt for yield with skyrocketing negative-yielding debt will push the search for yield to the extreme: there is almost $1.5tn tof bonds outstanding in “zombie companies”. The temptation for investors to accept lower quality in their portfolios is high, as is the bet that interest rates will remain low forever. This is dangerous.
The stage may well be set for a great reflation.
Many of the expressions [of this reflation] have been out of favour for the best part of a decade. Most market participants, and consequently their portfolios, are heavily conditioned from decades of disinflation or low inflation.
The change in the inflation regime, and subsequently the investor mindset, will likely have profound implications for asset allocations.
What concerns me most is sentiment. The success of the market itself recently has bred what I think is its greatest risk, which is overly optimistic sentiment. In and of itself, stretched sentiment doesn’t portend an imminent correction, but it does mean the market is likely more vulnerable to the extent there is a negative catalyst, which could come in any number of forms.
The pandemic has completely reworked our free-market economic system based on competition, risk management and fiscal prudence. It has been replaced by cycles of increasingly radical monetary intervention, the socialisation of credit risk, and a national policy of moral hazard.
This is troubling, as beyond the eyewall lies a poor credit environment judging by credit defaults, rating migration, and corporate fundamentals. In aggregate, the high-yield [debt] market has 4.5 times more debt than last 12 month earnings before taxes and other items, a ratio that already exceeds the 2008—2009 default cycle peak, and is likely to worsen from here.
It’s amazing to me that the market has moved past the “Blue Sweep” idea [of Democrats winning control of both houses of Congress and the White House] . . . I think we could see a “Blue Sneak”, as Georgia’s Senate races are still very much in play to go blue. That could open up the fiscal spigot even more.
I still believe this will be a golden era for credit, but I’m probably more worried about this thesis than I was back in April. Everything is happening at warp speed, so maybe dividends, buybacks and M&A come back quickly as well.
The biggest market risk continues to be inflation. I think it will only move temporarily higher next year due to base effects and then come back down. But the risk is that it continues to move higher, and that changes everything. We're putting a lot of faith in the Fed to stand its ground and not respond to accelerating inflation. If the Fed loses its nerve, and gets worried about inflation sooner than what they've intimated, then that could be a problem for markets, causing a kind of “Taper Tantrum 2.0” scenario.
The US dollar has crept lower this year, but could at some point fall precipitously. If that happens, the Fed will lose the flexibility of negative [real] interest rates, and may even be forced to pause asset purchases. That's the tail risk scenario.
If there’s no Blue Sweep [in January’s Georgia Senate elections], then the Fed is the back-up. But if you lose the back-up, then the world could be in for a rude shock. It’s plausible, it’s not that crazy a scenario. If the dollar goes significantly lower, then the Fed could run out of easing options, which would lead to an equity sell-off.
Financial markets have held together because of low policy rates and low bond yields, and lower discount rates have supported asset prices and suppressed government debt costs.
Although emerging-market debt burdens are (mostly much) lower than developed-market ones, yields are not, so debt servicing costs have not been suppressed to the same degree. EM central banks have cut rates as aggressively as DM ones, but bond buyers have been more cautious. Unlike DM, EM central bankers have not had the benefit of the doubt.
Turkey is especially instructive — a government refusal to recognise balance of payments constraints led to the need for a near-unique aggressive rate hike. This is the example of what we see as a broader risk: if EM policymakers do not continue to recognise that they face much tighter constraints due to the balance of payments than their DM counterparts, they risk a debt spiral that seems a very remote possibility in DM.
Letter in response to this article:
Beware ‘optimism bias’ in market predictions / From Malcolm Gooderham, Senior Partner, Elgin Partners, London W1, UK