When the conviction of the market crowd is as bullish as it is now, some long-term investors find it hard not to feel a twinge of unease.
Driving this has been an emphatic consensus view — equities will be lifted by the prospect of vaccines opening up economies hit hard by the Covid-19 pandemic, thereby releasing pent-up demand and unlocking high household savings.
Add in supportive central banks and the likelihood of additional fiscal stimulus early next year, and many investors see the makings of a robust market recovery. Ed Yardeni, a strategist with a bullish persuasion, thinks there is even scope that the current rally could launch a “roaring twenties” decade.
Evidence of a global reflation trade picking up the pace is now showing up in emerging markets and some commodity prices, two barometers of confidence in an improving economic outlook.
The International Institute of Finance noted this week “the largest ever one-month inflows for emerging market equities and debt” at $39.8bn and $36.7bn respectively during November. And commodity prices led by copper and iron ore both climbed to seven-year highs this week.
At the same time, there has been recent broad weakness in the US dollar amid expectations of only a limited rise in 10-year and longer term interest rates during the next 12 months.
A weakening reserve currency matters for a global economy with large dollar-denominated debts. It also boosts foreign revenues for US-based multinational companies and pushes up inflation expectations.
But investors with long memories know how markets often puncture hubris.
“We are all saying the same thing,” says David Riley, chief investment strategist at BlueBay Asset Management. “The reflation scenario is a rock solid consensus.” He cautions that it may not last beyond a “catch-up trade”.
So what could disrupt the current market consensus for 2021?
An obvious starting point is the rollout of various vaccines. Any delay in implementation or resistance towards mass vaccinations early next year will hamper a smooth reopening of economies, with the potential for chipping away at upbeat growth and corporate profit estimates.
Currently investors are buying into analyst expectations of a chunky 20 per cent recovery in global corporate earnings growth next year, mindful that, coming out of a recession, those countries hit the hardest usually benefit the most.
Within the MSCI All World index, trailing earnings per share are currently about 15 per cent below the 10-year real trend, according to Oxford Economics. However, this masks “wide variation at the individual market level”, with Europe and non-Asia emerging markets lagging behind the most.
A bumpier pace of recovery in the coming months would renew focus on high debt loads accumulated by companies and governments this year on top of already elevated starting levels.
Some investors are mindful that the 2008 financial crisis was followed by debt aftershocks convulsing the eurozone from 2010 to 2012 and then a credit crunch in emerging markets in 2013 and 2014.
For now, the equity market rally suggests a degree of comfort with current high debt levels. That stance is underpinned by expectations that central banks will keep interest rates at ultra low levels.
But buyers of the global reflation trade may face an uncomfortable reckoning at some point. Sustained strong growth means higher interest rates and potentially a more resilient US dollar that hits bullish global markets.
This highlights the importance of central banks and whether the US Federal Reserve does signal an exit strategy from its accommodative approach to monetary policy. An inflationary surge, dismissed by many due to the large output gap in many economies, would also warrant higher interest rates. In turn, that would reduce the valuation premium for growth stocks.
“Equity investors could be looking to ‘have their cake and eat it‘, with the view that easy policy and a vaccine can restore economic growth and earnings but with rates unchanged,” notes Absolute Research Strategy.
Conversely, modest growth and low consumer-level inflation are the usual consequences from economies with excessive debt loads. Secular stagnation and low bond yields may well prevail once the current reflationary breeze ebbs.
That raises an important aspect of what has been an extraordinary year for markets and the global economy.
The sheer amount of stimulus and pandemic disruption opens the door to what David Bowers, co-founder of Absolute Research Strategy, calls “a range of outcomes for equity investors that are maybe much broader than many realise”.
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