Rational bubble puts markets on high starting point for 2021

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After navigating a global pandemic, financial markets begin 2021 with a case of déjà vu. Just like 12 months ago, bonds and equities are kicking off January at expensive starting levels.

The human and economic toll of COVID-19 has left deep scars that will take a long time to heal. However, for markets, 2020 ended up being a remarkably strong year after the initial fright in March when the novel coronavirus started to spread.

For those investors who stayed the course from the beginning of the year, there were double-digit gains from U.S. and global equities and solid returns from bond markets. The U.S. benchmark S&P 500 index was had an annual gain of more than 16 per cent while the MSCI World Index was up just more than 14 per cent. The Bloomberg Barclays Global Bond Index was showing total returns for the year of about 9 per cent.

“What was seen as being extreme a year ago has only become more so,” says David Kelly, chief global strategist at J.P. Morgan Asset Management. “Valuations for stocks and bonds are higher from a year ago. Investors should also recognize that, after a surprisingly good year for portfolio returns, asset prices look stretched.”

The market trend is in some ways a rational bubble given expectations that sustained low interest rates will compel investors to own more equities and higher-yielding corporate bonds of lower credit quality.

“About four-fifths of the world’s investment-grade debt yields 1 per cent or less,” says a note from Citi Private Bank strategists. “Investing in productive assets will be necessary to earn real returns. That is especially good for equities.”

Buoyant equity prices and valuations reflect a bullish outlook for profits and economic growth in 2021 on the back of a vaccine-powered rebound. Support from governments and central banks also should extend over much of 2021, with the aim of bridging the gap until consumers and companies eventually spend their accumulated lockdown savings.

“The fog of uncertainty from the pandemic is clearing and from enormous pent-up demand, there will be a simultaneous global recovery in the second half of 2021,” Mr. Kelly says.

Strategists say this means investors should look beyond richly valued large U.S. companies toward emerging markets, cyclical industries such as banking and energy, and small and mid-cap companies.

That shift has already started, with equity market leadership broadening out from the so-called pandemic winners. Since November, there has been a rush into the laggard areas of equities and bonds for companies that typically benefit from a reflationary economy.

But rebounding economic activity should warrant higher longer-term interest rates and at the very least, spur market uncertainty about just how long central banks will stick with their bond-buying policies. This will become an increasingly hot topic should the global economy not only meet but exceed current International Monetary Fund expectations of 5.2 per cent growth in 2021.

The crushing of interest rates by central banks has significantly reduced risk premiums across the financial system. That is best illustrated by a “real” U.S. 10-year Treasury bond yield sitting near minus 1 per cent after taking inflation into account. This yield was flirting with breaking below zero a year ago. It is, therefore, reasonable to envisage a rise back to that level in the coming year – a prospect that could knock highly valued shares.

“Global equities, in particular, are at high valuations and now extremely sensitive to rising yields,” write analysts at TS Lombard. But in what is a widely-held view, they “suspect central banks would act swiftly to try to correct any major tightening in financial conditions.”

This expectation of further support from central banks has kept asset prices climbing for now. Market sentiment ended 2020 full of ebullience, demonstrated by the crowding of investor money into popular assets such as Tesla Inc. (TSLA-Q) and bitcoin.

This is where one lesson from recent market history becomes pertinent now that we’re in 2021. During the past five years, volatility measures for equities and bonds show a pattern of generally tranquil conditions for much of the time. Then, the music suddenly stops and volatility spikes.

This time last year, Alberto Gallo, portfolio manager of the Algebris Global Credit Opportunities Fund, increased the cash weighting in his portfolio. Starting in 2021, he is repeating the move as markets move into what he says is a “euphoric phase.” A third of the fund has been put into cash and hedges on assets. Investor Bill Ackman also hedged his equity exposure in November by purchasing insurance against corporate defaults.

Another strong year for equity markets will penalize such investors for holding high cash levels or hedging exposures. But given the overwhelmingly bullish investor consensus and crowding into popular areas of markets, it would be surprising if asset prices avoid a serious wobble at some point in the next 12 months.

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