According to the Merriam-Webster online dictionary, ‘pandemic’ is the most-searched word of the year. COVID-19, a once-in-a-century pandemic, which started in Wuhan, China, brought the world to a halt with more than 1.79 million deaths recorded to date. The same pandemic saw buoyant markets and high expectations of inflation.
This huge disconnect between Wall Street (capital markets, large corporations and high-net-worth investors) and Main Street (average citizen, small businesses or the real economy) will be the main takeaway for investors this year. This article discusses divergences from what investors may have expected during a pandemic and the economic realities, buoyant equity markets and high inflation.
Buoyant equity markets
How would a headline, ‘A pandemic lifted the world equity markets to an all-time high’ sound to an investor? Obscene, to say the least; yet this was the narrative for 2020.
The technology-driven US stock market stands over 14% higher versus this time last year, taking the world market to around 12% higher, even though the European stock market is still some 10% below its mid-February peak. Investors who decided to be cautious and stay on the sidelines when COVID-19 broke out are no doubt curious why the aggregate equity market is at an all-time high when the pandemic continues to ravage the global economy.
The explanation is record low bond yields!
Equity valuations rise when bond yields decline. When bond yields approach their lower limit, bond prices approach their upper limit. This means that the scope for further price elevation diminishes while the scope for price collapses increases.
In short, the lower the bond yield, the lower the opportunity to make a positive return from bonds. As bond returns diminish, the excess return on equities relative to bonds, known as the Equity Risk Premium, narrows towards zero. Logically, if the riskiness of equities and bonds converges, any risk premium must disappear. Consider the Swiss 10-year bond for instance: the bond price can barely rise yet it can fall precipitously. Even more recently, the Italian, Spanish and Portuguese 10-year yields – falling to their lowest levels on record – has left limited upside potential for bonds.
The result of lower bond yields is that the prospective return, known as the ‘discount rate’, required on equities, declines exponentially, because both of the two components which make up this discount rate, the bond yield and the equity risk premium, are positively correlated and will decline in tandem. Given that valuation is the inverse of the discount rate, the valuation of equities rises exponentially when bond yields decline to ultra-low levels. Conversely, the valuation of equities falls exponentially when bond yields rise from an ultra-low level.
In hindsight, it appears that the appropriate aphorism during the pandemic would have been, ‘Focus on valuations and not profits’. The dramatic swing in valuations was driven by the dramatic swing in bond yields as central banks across the globe responded to the pandemic. This was hardly surprising, given that the prospective return on equities is sensitive to the prospective return offered by bonds. But at ultra-low bond yields, this sensitivity becomes hyper-sensitive, lifting equity markets higher.
Invariably, inflation fell in the early stages of the pandemic, mainly due to significant declines in prices for the worst-affected sectors such as energy and hospitality. As restrictions started to ease, prices for those goods and services began to rebound and that reflation has been compounded by inflationary effects in other sectors.
The upshot has been that, despite the initial deflationary impact of the pandemic during the lockdowns, inflation is already rebounding more rapidly than normal for this early stage of the economic recovery. Because the lockdowns triggered declines in both production and spending, with the latter recovering more quickly than the former, inventories are unusually lean for this stage of the economic cycle, which is putting upward pressure on goods prices. In addition, ongoing physical distancing restrictions have increased costs and reduced supply in many services sectors.
Just as globalisation and the dismantling of trade barriers put downward pressure on prices of goods in recent decades, deglobalisation could have an opposite effect. The pandemic may further accelerate the deglobalisation trend that has been building up as a result of trade wars and the decoupling chants. This will inevitably exacerbate global shortages of some key goods, exposing the dangers of over-reliance on imports and complex global supply chains, putting upward pressure on prices.
The pandemic generated huge increases in government debt across the globe, as countries implemented fiscal policies to help their economies stay afloat. A case that demonstrates this burden has been Zambia, which became the first African country to default on its debts since the pandemic began, leading to fears that more defaults could consume the continent, which is heavily indebted. While cognizant 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 encourages price increases that reduce the real value of that debt, ultimately inducing inflation.
In the US, the Fed’s recent shift to a form of average inflation targeting suggests that inflation compensation could rebound more strongly during the economic upswing than in recoveries of the past. The aim to generate inflation above 2% to make up for the past shortfalls suggests that the central bank will probably keep policy very loose for some time, even if actual inflation starts to pick up. While across the pond in Europe, the European Central Bank has already started to consider an inflation overshoot, echoing the Fed’s strategy.
Overall, beyond the near-term forecast horizon, the pandemic has left the balance of longer-term risks to inflation more skewed to the upside. In particular, more activist monetary policy could eventually lead to a bout of higher inflation, not because central bankers don’t have the tools to rein in demand, but due to pressures from politicians and society more broadly not to use them.
Wrapping up 2020
Even though families and friends did not travel much for holiday gatherings this year due to lockdowns, Santa Claus still had a special way of wrapping up the year for the stock markets. As we wrap up 2020, we remain optimistic surrounding the rollout of COVID-19 vaccines across the globe.
Wishing every investor a prosperous 2021.
Richard Maparura, CFA, Senior Portfolio Manager, Butterfield Bank (Cayman) Limited
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.