It has been a head spinning year for investors. The global Covid-19 pandemic triggered a stunning rout in equity markets. Then came a sharp recovery driven by the rapid response from governments and central banks. Here’s a look at that year in charts and what they suggest for 2021:
The key to this year’s rebound in equities and corporate bonds from the lows was the sheer scale of central bank support.
A gush of government bond purchases has anchored long term interest rates at extremely low levels and will continue during 2021, albeit at a reduced pace. JPMorgan’s strategy team expects $5tn of global central bank balance sheet expansion in 2021. “Central bank balance sheet expansion in 2021 might be only half of 2020, but that pace would still be associated with asset price inflation,” it says.
Tech and high quality stocks led the way from the depths of March, but during the second half of the year, investors started rotating towards stocks more sensitive to the economic cycle, cheaper “value” stocks and high-yield bonds. That has been spurred by expectations of a broader economic rebound next year as vaccines for Covid-19 are rolled out. Regulatory approvals of vaccines have accelerated the pace of a broad market rotation, with smaller companies seeing strong gains.
The bounce from March is certainly impressive but does raise a concern that markets have borrowed heavily from 2021 returns. Global and US share markets are set to record two consecutive years of double digit gains and history suggests that a string of three straight years of double digit gains is rare but can occur.
So does 2021 extend the streak? Or will already high valuations weigh on returns?
The answer rests with the scale of an anticipated corporate earnings recovery next year. As shown here, the current consensus estimate for bottom-up earnings per share for the S&P 500 for the 2021 calendar year is $169.20, which would represent an increase of 21.7 per cent from 2020. That would represent a record high EPS for the blue-chip benchmark and would come after a forecast earnings decline of 13.8 per cent in 2020.
One wrinkle is that estimates by Wall Street for earnings over the next year are usually 7 per cent too high according to John Butters, senior analyst at FactSet. Apply that factor and 2021 EPS would deliver an actual figure of $157.32, falling short of the 2018 and 2019 actual EPS numbers of $161.45 and $163.02 respectively.
However, there is a case for arguing earnings might be one area that positively surprises. The pandemic sparked a dramatic effort by companies to hoard cash via costing cutting and the slashing of buybacks and dividends.
“Companies did not view this as a normal recession and cut their costs to the bone in order to survive,” said James Paulsen, chief investment strategist of The Leuthold Group. “Minimal costs on an operational basis means rising demand powers up profits.”
An earnings rebound next year is critical because valuations sit well above their average levels. Higher earnings will reduce extended valuation multiples over time. But as shown in this chart below of trailing 12 month price to earnings per share by Northern Trust Asset Management, all the main regional markets sit above their long term average.
Wall Street certainly stands out for being more expensive than rivals. This might favour emerging market equities in 2021 and more cyclical companies. The argument is that they will experience a bigger bounce in earnings growth from a stronger economic recovery and a weaker US dollar.
The dollar’s performance is important because it helps boost global growth and corporate earnings. The chart below highlights how Wall Street can lag the rest of the world arise when the reserve currency enters a sustained bear trend. Rising local currencies help boost returns for global investors holding non-US equities.
A broader and more global equity rally suggests better times for advocates of buying value stocks, cheap companies that over the past decade have badly lagged the performance of faster growing rivals. As seen here, the ratio of value versus growth companies has recently turned upwards, but it paints a sorry picture since 2007.
Expectations of a robust recovery that accelerates during 2021 hinge on a return to normal after mass Covid-19 vaccinations. But “normal” in a financial market context means higher long-dated interest rates.
The Bloomberg Barclays global bond index includes government and corporate bonds that are investment grade quality. Falling yields have been a pervasive and entrenched trend. The global index with an average maturity of 9 years, currently sits at 0.84 per cent, down from 2.79 per cent over the past decade.
The persistent decline in bond yields against the backdrop of low inflation and the bulging presence of central bank balance sheets over the past decade leave investors in a degree of suspense from here. No one can be certain that a decade of secular stagnation will cede to a cycle of faster, more inflationary growth that is more inflationary, thereby rewarding equity holders and threatening returns for bond investors.
“While equity investors are welcoming the 2021 growth cycle, bond investors continue to focus on the longer term where growth will probably resume at a slow trajectory and inflation will remain a problem for another day,” says Katie Nixon, chief investment officer at Northern Trust Wealth Management.
michael.mackenzie@ft.com