Are we worrying enough?

When so many people agree about something, there is always the worry that things may not be as bright as they seem. Is this the case with the optimism about a recovery from the pandemic?

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  1. Charles Stanley

Many professional investors and commentators are bullish on equities. They see a strong recovery coming in the major economies as winter passes in the northern hemisphere and as lockdowns and vaccination programmes bring the pandemic infection numbers right down. This should permit substantial relaxations of controls on business and social activity and release pent up spending power amongst the many who have kept their jobs and their incomes.

As the limitations on spending caused by bans on travel, hospitality and out of home entertainment are lifted, so more activity will take place.  They expect the Fed, ECB, Bank of Japan and the Bank of England to keep official interest rates very low, to offer more support to markets by buying bonds and to phase out the big fiscal stimulus designed to cushion and prevent job losses only gradually. This is also our base case assumption for 2021.

When so many people agree about something there is always the worry that they have already made their investments. We need to ask who will do the next buying to validate the prediction that markets will go up?

So far this year there have been plenty of buyers around. Some individuals and funds held cash which they can commit. Some are wanting to run a bit more risk, selling some government bonds to the central banks and placing the money into shares. We will watch cash levels and buying patterns, as a continued flow of new money into shares is an important driver of ever-higher valuations.

Fundamentals count

We will also watch the reports of profits and dividends, as part of the case for shares is they are not as dear as they currently look, as earnings are about to rise strongly. Those high looking multiples of profits and low yields will become more realistic as dividends and earnings accelerate.

That leaves us with one remaining worry. Why are there not more things to worry about?  The truth is there are still ways that equity markets later this year can take fright or change the mood. There are various risks we monitor that could change the goldilocks scenario.

The first is worry about the authorities themselves. Most agree that this bull market phase is sustained by the loose-money policy. Inflation is going up a bit, with many commentators assuming it will go up by an acceptable amount. As the Central Banks both want and expect a bit more inflation, a drift up to a little over 2% is unlikely to lead to any change of policy.

Were inflation to exceed expectations and to look more persistent Central Banks might become more orthodox, prompting a further sell-off in government bonds, a rise in interest rates and a nasty jolt to share prices.

The second is the health of the corporate sector. Last year was remarkable both for the sharp deterioration in cash flows for a large number of badly damaged sectors and for the low bankruptcy rate.

Banks and markets were accommodating with loans and equity financings. Governments and central banks assisted in keeping businesses together financially. Were the strains of financing a pick-up in activity and a return to work to encounter less helpful banks, we might see more problems. The declaration of more non-performing loans and more bankruptcies could cause difficulties in credit markets which would transmit to shares.

The third is the patience and elasticity of the governments. Fiscal policy has been stretched on both sides of the Atlantic to boost the incomes of those losing jobs or in furlough. States have assumed a bigger role in many fields, led by their spending on pandemic control and health. If Treasuries become too cautious too soon, raising taxes and cutting spending, this could hinder recovery and spook markets.

Trade woes continue

Meanwhile, we need to note that global trade will be stressed by a range of new conflicts and frictions. The US/China relationship will be conducted in more diplomatic language by President Biden, but there are a widening range of items which the two sides now restrict. Technology bans are spreading to threats about rare earth metals, which are essential in the technology sector and China processes most of the supply.

Each side is examining the others' defence procurement to see where they have trade leverage. Hong Kong will not win back a more privileged trade status from the USA given the human rights issues. Many places are pursuing a more nationalist line over everything from defence procurement to vaccines and technology. Countries are insisting on more domestic production to accompany new investment.

Next week we will look at the general prospects for the great companies of the digital revolution. These prospered mightily last year from winning even more business growth out of lockdown. They led the strong performance of the US share market which in turn led the world. This year will see new pressures arise affecting these businesses. This week Australia has tested the issue of free news circulation by social media platforms. This year there will be many pressures from many governments for more tax and regulation of the digital giants.

There are still things to worry about. The higher these equity markets go the more we should worry about what might bring a change of mood and policy. For the time being, shares are supported by the strong expectation of recovery and benign policy action by the main central banks and governments.

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