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Happy New economic cycle?

Wintery city scene

For financial professionals only

There are three obvious drivers that move markets. Valuation – whether something looks under or over-priced; Liquidity – whether we can easily access and exit an investment; and Sentiment – how do investors feel about markets today?

Sentiment drove markets in Q4 2020 – in both directions. Concern around a Democratic sweep in the US election – traditionally a bad outcome for business – led to soft markets in October, followed by relief at Biden’s victory when it came to pass in November.

Positive political surprises were abundant, as the prospect of Trump realistically contesting the result faded quickly, US Congress approved a supplementary $900bn Covid-19 aid bill, and a trade deal was agreed between the EU-UK ahead of the deadline.

Low expectations around Covid-19 vaccines were also curbed by efficacy rates into 90%+, speedy approvals across the globe, and the mobilisation of rollouts.

These factors buoyed investor sentiment, fuelling a rally in equity markets with a number moving towards their highs for the year. In the US, the S&P 500, Dow Jones and Nasdaq all reached all-time highs.

The role of central banks

With both monetary and fiscal policy expected to remain supportive through the recovery, long-term US Treasury yields nudged higher, albeit remaining some way below the pre-Covid levels, as seen in the chart below.

US 10-year treasury bond yield

Source: Bloomberg and Grizzle.com

Central banks are continuing (and in some instances, expanding) their QE programmes – buying up debt from governments as well as some corporates in an attempt to keep the cost of borrowing low and ensure stable liquidity in the system.

As a temporary exercise this was necessary but having been in place since the Global Financial Crisis of 2008/9, it’s fair for investors to be wary of it today. That said, the nomination of former Federal Reserve Chair Janet Yellen as Treasury Secretary in Biden’s administration has been taken very positively by the markets, seeing her as a moderate who’s unlikely to concede to excessive fiscal expenditure programmes.

Changing factor momentum

For many years now growth stocks have outperformed their value counterparts, and within that US large cap tech has dominated. But with a Biden administration raising the prospect of new regulations on big tech companies, the status quo looks vulnerable to change.

Combined with expectations of a stronger economic outlook, this means the more cyclically oriented sectors – which tend to make up value indices – started to attract investor attention, as did smaller cap businesses, which would be expected to perform well in a recovery phase

Short-term moves were notable, but not sustained given all the uncertainty around Covid-19 as we enter a challenging winter season. Indeed – the IMFs World Economic Outlook revealed persistent negative output gaps across much of the western developed world through to 2023.

Slower relative GDP growth projections into 2021/22 also weighed on the US dollar, which continued to depreciate, its safe-haven status appearing less necessary when global growth prospects are picking up. For context, the IMF expect China to achieve 1.9% GDP growth in 2020 and over 8% in 2021. Looking at longer term secular trends, this points to a continued rise of China on the global economic stage relative to the US, as seen in the chart below.

 

US & China share of world GDP (PPP basis)

Source: IMF and Grizzle.com

Expectations are high, time to deliver

Bullish strategists and financial commentators have predicted the start of a new economic cycle as the world recovers from the recessions of 2020. But as we enter another lockdown, we know the road ahead will have peaks and troughs. For that reason, maintaining a diversified portfolio able to withstand these undulations is paramount.