As is customary in December, analysts start to publish their economic and market forecasts for the following year. Of course, the challenge is that it is impossible for human beings to see the future. Given the unprecedented events this year and the nature of the COVID episode most forecasts made at the end of 2019 for this year would likely appear particularly foolish. However, that simply reinforces our conviction that it is more important to focus on large asymmetry in valuation (risk compensation) positioning and beliefs rather than spot price forecasts on growth, earnings or index levels. Stated differently, rather than focus on what might go right, we prefer to determine what is probably wrong.
The nature of the 2020 crisis (a global pandemic) contributed to once-in-a-century swings in the economy, policy and markets. The speed and size of the drawdown in equities and credit was among the largest in history. However, the size and scope of the policy response was also the earliest, broadest and biggest in history. The $10.5 trillion in central bank liquidity combined with the largest fiscal response since WWII has kept bond term premia and credit spreads much more contained than in past crises (relative to the GDP shock). There are a few forward looking points to note.
First, historical experience of past cycles suggests that the expansion ought to continue. However, it is plausible that the economy and markets will experience a phase of consolidation (or even correction) at some stage next year. Markets care about the rate of change. As we have often noted, it is the change in credit or fiscal policy that matters for growth not the level. On the positive side, the cyclical tailwinds following a recession are powerful. While that is partly a function of the starting point, the natural state is for economies to grow and corporate earnings to expand. Put another way, equity prices should rise over time.
Second, the more important point is to assess where attractive risk compensation still exists, following one of the most extraordinary rallies in equity prices from the March low. The good news is that equity risk premium or the difference between the earnings yield on equities and yield on sovereign bonds is still historically wide. Of course that is partly a function of the explicit goal of policy (through financial repression) to make government bonds as unappealing as possible compared with other assets. However, it is not obvious that an unattractive purchase necessarily makes a compelling sale. Similarly, equities ought to be considered in the context of profits and growth, not simply compared to the alternative asset.
Third, the nature of the crisis, policy response and recovery suggests that there is still large anomalies and considerable opportunity within the equity and credit markets. As has been the case over most of the past decade, the prevailing bias is that low growth, low inflation and interest rates are a permanent state. To be fair, policy (through financial repression) has reinforced this belief. It is a legitimate reason for the underperformance and discount applied to sectors like banks as it has had a genuine influence on profits. While there is evidence of reflation in absolute and relative equity performance at an index and sector level, the valuation anomaly between equities with “growth” and “value” characteristics is still rather extreme. Value equities in emerging markets (Asia) still trade at a 70% discount to US equities and not far above the discount seen after the 1997 crisis. We also see 300 basis points of additional risk compensation between Asian and US high yield credit (for comparable credit quality).
Fourth, the related anomaly caused by financial repression is unusually low fixed income volatility. On a normalized basis, bond volatility is extremely depressed relative to equity volatility and compared to history. Put differently, the cost of protection or insurance for a rise in yields is extraordinarily low. There are a lot of compelling arguments for higher yields. However, in the near term the three arguments against are; 1) the risk that the expansion might moderate in 2021 as the fiscal impulse fades; 2) the Federal Reserve. The Fed is still averse to pre-mature tightening following the 2013 “taper” episode; and 3) inflation tends to rise with a material lag. As we have noted previously it may not be until 2022 until output gaps close sufficiently (excess capacity is worked off) and consumer prices start to rise on a sustained basis that causes central banks to respond.
The final point to note is that a global expansion is usually associated with US dollar weakness (most of the world’s reserves and liabilities are still held in dollars). However, we would note that dollar weakness is a widely held consensus belief and there has already been a material depreciation in the dollar and recovery in non-dollar assets (such as emerging markets). The US dollar is also overvalued and the twin deficits ought to lead to trend dollar depreciation over the medium term. In spite of the recovery in non-dollar currencies, asset managers are still generally underweight the latter.
In the context of the observations above, we have the following non-predictions for 2021 (more detail to follow).
1. US high yield will not outperform Asian high yield in 2021
2. Bond volatility will not end 2021 lower than today’s spot level
3. The IDR will not underperform the TWD in 2021
4. US equities will not outperform a basket of Asian banks in 2021
5. US technology will not outperform Asian technology in 2021
About the Author:
Nick Ferres is CIO of Vantage Point Asset Management. Prior to this, Nicholas was at Eastspring Investments, the Asian asset management business of Prudential plc, as Investment Director, in September 2007. Nicholas was Head of the Multi Asset Solutions team and was responsible for managing the global tactical asset allocation of funds for external institutional and retail clients. Before joining Eastspring Investments, Nicholas worked for Goldman Sachs Asset Management as Investment Strategist & Portfolio Manager. He has more than 20 years of financial industry experience. Nicholas holds a B.A. (Hons) in Economic History and Politics from Monash University, Australia, a Graduate Diploma in Economics and a Graduate Diploma in Applied Finance.