Given the excellent Q4 corporate earnings reported in recent weeks, the equity market euphoria at the beginning of the year theoretically needs no explanation.
But it seems that financial markets are more generally governed by other factors these days. We call it the V.I.S.A. syndrome:
- Vaccines: vaccination campaigns are proceeding at different paces and this is what is now driving the 2021 growth outlook. The United States and the United Kingdom have a distinct advantage while the Euro Area is lagging;
- Inflation: in just a few months, investors have shifted from fears of a recession to fears of renewed inflation, sparking the rise in long term yields. The risk is that they have likely overreacted: after all, beyond the short term base effects, which we had anticipated, unemployment remains high and the deflationary pressures of the previous decade remain in place. However, a new economic policy equilibrium could make all the difference;
- Stimulus: it is increasingly likely that there will be an agreement on a massive fiscal stimulus package in the United States, in an already rebounding economy that is set to meet the vaccination challenge before the middle of the year. This is leading to both higher growth expectations and fears of excessive fiscal support;
- Accommodation: we find ourselves in the unusual position of having a very rapid rebound in the US economy even as the Fed intends to maintain its accommodative stance until 2023. The markets’ real concern is therefore that the recovery could turn into an overheating mode and prompt the Fed to abandon its zero-rate policy.
Behind this acronym may lie a change of regime, or at least a new equilibrium driven by the most procyclical economic policy ever seen, in a US economy already projected to grow by 6% this year. Ultimately, it is impossible to say right now whether this recovery will lead to a faster and more sustainable acceleration in wages and inflation. One thing is true, however: a stronger recovery should translate into a rapid decrease in unemployment, which could again raises the question of whether the Fed will normalise short term rates. It has ruled this possibility out for now.
Therefore, the question economists are now asking is how to assess the risks that may arise from fiscal support that everyone has called for, but whose positive short term impacts on growth could eventually be offset by monetary normalisation.
Long term yields did not wait for the Fed or for economist responses and began to steepen again last summer. This steepening leads to two new factors. The first is more a painful reminder than a true discovery: the Fed does not control everything and especially not 10-year yields. The second is that long term yields reflect not only inflation expectations (which could stabilise), but also the strength of the recovery (which is boosted by the stimulus).
This creates a complex equation for investors: hold on to bonds which are starting to plateau or sell them to buy more volatile equities, some of which are not immune to rate hikes? Is there still time to hedge or are there equity styles that benefit from this reflationary environment?
Monthly House View, 19/02/2021 release - Excerpt of the Editorial
February 23, 2021