After the historic global events of 2020, and with a new president in the White House and the ongoing COVID-19 pandemic, January’s Market Voice analyzes the prospects for trading markets in 2021.
- What impact will Joe Biden as the new U.S. president have on trading markets?
- The rally in trading markets, initially ignited by Federal Reserve fiscal stimulus, seems to reflect a belief that the vaccination program will return life to near-normal by the summer. However, deeper analysis shows that the market may have priced in a very optimistic outlook for the economy.
- What impact will the Fed’s fiscal stimulus have on the prospects for high inflation? And how will major currencies fare during 2021?
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It is hard to imagine a year which we will be so happy to have behind us.
While 2021 should be a substantial improvement on 2020, the degree and speed of improvement is subject to a still uncertain pathway for rolling out the vaccine. Indeed, as the year closed, global fatalities were pushing toward record highs and the virus has morphed into more contagious forms.
The impact of the new U.S. president on trading markets
One thing we can say with reasonable certainty is that come the Inauguration on 20 January, Joe Biden will be the president of the United States.
Figure 1 is an update of the data we showed a year ago on the implications of the election for stock market performance. Red lines indicate a Republican victory and Blue denote Democratic wins. Bold lines indicate the incumbent president was re-elected — including President Johnson.
There is no evidence that there is a direction in trading market bias in either the month after the election or over the subsequent year. Consistent with this, the market put in strong one-month rallies following both Biden’s victory this year and Trump’s win four years ago.
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That said, there is a modicum of good news for the market. Performance over the subsequent year has been better, on average, with a Democratic win. In 71 percent of the Democratic victories the market did better in the subsequent year than in the year prior to the election.
For Republicans the market outperformed in only 41 percent of their wins. And in outright terms, the market gains 15 percent on average in years following Democratic wins and only 1 percent in years following Republican victories.
How much good news is in the market?
The trading markets rally in the month following this year’s election to some degree reflects expectations of additional fiscal support to offset the dislocations from the pandemic.
The market is almost certainly priced for a successful roll-out of the vaccine, allowing a return to near-normality over the summer months. It is therefore prudent to assess how much good news is reflected in near record stock prices.
As shown in Figure 2, the SPX dividend yield spread vs both the 10Y Treasury rate and the AAA corporate bond rate has dropped sharply from the highs seen in the wake of the March COVID-19-triggered sell-off.
Equity dividend yield dropped sharply (largely due to rising prices) in the second half of the year and at 1.95 percent is near the decade low — i.e, stocks seem expensive. But as has been the case for the past few years, stocks may be expensive in absolute price terms, but they are cheap relative to pricing in other asset markets.
The spread vs the Treasury rate is back to pre-COVID-19 levels, but that still leaves it at levels which are historically wide. The same is true for the spread vs corporate bonds.
Figure 2: SPX dividend yield vs 10Y U.S. Treasury and AAA corporate bond rates
Valuation of the market versus the broad economy
The notion of the market being “cheap” seems at odds with the disconnect of stock prices rallying to new highs even though the economy has yet to fully recover and is still beset by high unemployment.
Indeed, a less optimistic picture of market pricing emerges from the valuation of the market versus the broad economy. Figure 3 shows the ratio of the market capitalization of the SPX (the cumulative market value of all stocks in the index) to nominal GDP.
Over the past two decades, the valuation of the stocks in the SPX has generally mean-reverted to about 90 percent of nominal GDP. During the 2000 dot-com bubble the stock-market valuation surged to a then record high of almost 130 percent of GDP and plunged to a low of just over 50 percent of GDP during the 2007 financial crisis.
In the wake of the financial crisis, the market-cap rose back to 90 percent but then moved to an extended trend of 110 percent. We posit that the higher mean valuation in recent years reflects the unprecedented Fed policy of a near-zero Fed funds rate.
The equity rally that emerged over the second half of last year largely reflects the extreme levels of fiscal and monetary support, as well as expectations of a return to normality on the horizon. But as the new year dawns, market valuation is at an unprecedented 150 percent of GDP.
GDP would have to grow 30 percent in the next year just to take market cap back to the highs seen in the dot-com crisis. The market has priced in a very optimistic outlook on the economy.
Figure 3 also shows the U.S. Treasury yield curve — as measure by the 10Y rate vs the 3M rate — on an inverted basis. The market tends to gain on GDP during period of curve flattening (rising orange line) and serious market downturns are accompanied by sharp steepening of the curve.
The Fed seems committed to keeping rates positive, and a zero boundary would make further flattening difficult. And any signs of inflation could steepen the curve, leaving equities seemingly much more vulnerable.
Figure 3: SPX market cap vs GDP and the U.S. Treasury yield curve (Year-end data)
This leaves us with a somewhat mixed picture for equities, they are historically cheap vs other assets but quite expensive relative to economic performance.
We suspect that cheapness will dominate during the first half of the year as the market will continue to focus on normalization down the road. The chief near-term risk is that government support does not prevent massive corporate insolvencies and millions of people being evicted from their homes.
The government seems poised to prevent this, but there are still scenarios that could spell trouble for the market in the second half of the year:
- The roll-out of the vaccine takes longer than expected and/or proves to be less effective than hoped, so the normalization of economic activity is delayed.
- The market normalizes in the second half of the year, but the rebound does not reach the sky-high levels built into market capitalization.
- The market does surge dramatically in the second half of the year, but concerns emerge that the Fed will respond by tightening monetary policy and/or fiscal stimulus will be scaled back.
The prospects for market performance in any of these scenarios would be more negative in the event of a significant pick up in inflation. Bond yields would almost certainly soar, causing bond prices to cheapen and the curve to steepen. The Fed would be hard pressed to keep monetary conditions easy with inflation surging.
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Will 2021 be the year of inflation?
The U.S. government is shoveling out stimulus at a pace not seen at least since the Second World War.
The U.S. fiscal deficit is approaching an unprecedented 20 percent of GDP taking debt above 100 percent of GDP for the first time since the Second World War. The Fed was still at near-zero rate policy when COVID-19 emerged, and has now expanded its security purchases in unprecedented ways to include municipal bonds and potentially corporate debt.
Inflation has remained low and insensitive to government action over the past two decades, but it is still possible that serious inflation could emerge in the wake of the double-barreled stimulus hitting the economy.
Figure 4: U.S. CPI (Y/Y) inflation and (12M average) capacity utilization
As noted above, inflation has not been very responsive to government action in recent years; indeed, the Federal Reserve has been struggling to get inflation up to its 2 percent target rate. That said, there is still subtle links between the pace of economic activity and inflation.
Economic theory says that the overall demand conditions in the economy should be a key driver of inflation and Figure 4 suggests this is still the case. There is a persistent link between the 12-month moving average of capacity utilization and the 12-month rate of inflation. But the relationship indicates that utilization plunged to 72 percent earlier this year and needs to tighten substantially before it will start creating inflationary pressure.
Based on the historic pattern, utilization needs to tighten well above 75 percent of capacity on a sustained basis for inflation to get above the desired 2 percent rate. Given that the economy is not going to normalize until well into the year, it is not likely utilization will hit these levels by year end.
Although the Philips curve relation between unemployment and inflation has been pronounced dead, Figure 5 shows that the pace of job growth still has influence. The blue line in the chart is the pace of year-over-year CPI inflation through the end of 2020. The black spots represent months when the unemployment rate was below 6 percent and the orange circles represent months when the 12-month moving average of non-farm payroll gains exceeded 175,000 (payrolls are volatile, so the 1-year average is more meaningful).
Periods of sustained inflation above 2 percent have been accompanied by low unemployment or rapid job growth, and usually both. Job growth was in the pressure zone in recent months but with unemployment still above 6 percent and, as noted above, capacity utilization still weak, this is unlikely to create a significant push on inflation. Moreover, the December data shows that the renewed shutdowns in response to the resurgent virus has slowed the pace of job growth.
We do believe that the extreme stimulus has the potential to eventually show up in surging inflation, but economic conditions need to improve significantly before this can happen. It will be at least the 2022 New Year’s celebration before we can toast the arrival of high inflation.
Figure 5: CPI (Y/Y) inflation in context of unemployment rate and payroll gains
Could 2021 be the year of the Japanese Yen?
As we enter the New Year, the dollar overall looks very uninteresting.
The dollar is roughly 15 percent stronger in real terms than it was 10 years ago, but it has been stable for the past five years. More importantly, there has not been any serious consequences from the strong dollar in terms of net trade performance.
As also shown in the Figure 6, the U.S. current account deficit is lower as a percent of GDP than it was 10 years ago and seems to have stabilized at a historically modest 2 percent.
On the margin, dollar performance is likely to be reflective of which countries make the most rapid progress in rolling out the vaccine, but in the absence of a significant widening of the deficit it looks like the dollar broadly should remain stable.
Figure 6: U.S. current account as a percent of GDP and the real-trade-weighted dollar
Monetary conditions paint a more mixed picture for the dollar. 10Y European government rates (proxied by German Bunds) have gained significantly against U.S. Treasuries, but the EUR has strengthened in line with the spread gains.
As shown in Figure 7, the EUR is roughly consistent with the current spread level so, as with the broad dollar, the EUR should remain fairly stable in the months ahead. The same is not true with the JPY.
Although the Treasury spread vs Japanese bonds has risen modestly in the second half of 2020, the spread suggests the USD should be at least 10 percent weaker than current levels. The implication is that the JPY could see some significant strength against both the USD and the EUR over the course of 2021.
Figure 7: USD bilateral strength tied to 10Y government rate spreads
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