I think I probably speak for almost all of us when I say “good riddance” to 2020. One of the worst parts for me was that constant sense of dread back in the spring, plus the loss of any semblance of a normal life routine. It was all a blur for a while.
While the pandemic has continued to affect the world, the markets did recover, but it came at a cost in the form of elevated volatility, which many investors were not able to withstand.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
In 2020, growth stocks won the battle, followed by Treasury Inflation-Protected Securities (TIPS) and gold. An interesting juxtaposition of growth and inflation hedges. At the bottom were REITs and commodities.
In my view, one of the reasons equities were able to step over the abyss following the plunge in March was the policy response on both the fiscal and monetary side. Here we see that the combined balance sheets of the Fed, the European Central Bank (ECB), the People's Bank of China (PboC), the Bank of England (BoE), the Bank of Japan (BoJ) and the Swiss National Bank (SNB) reached 25% of global GDP.
Arguably, the Fed has been winning this race to the bottom, and this has created a lot of negative momentum for the US dollar, and therefore positive momentum for commodities and gold and bitcoin.
The spike in liquidity, measured here as the difference between M2 growth and GDP growth, also bled into equity valuations, which expanded 34% in 2020. (M2 is a measure of the supply of money in the economy. It includes cash, checking and savings accounts, and some types of investments like retail money market mutual funds.) Expensive valuations were a big part of the wall of worry for investors in 2020.
The liquidity spike has led many investors (including this one) to wonder whether rising inflation will eventually become part of the landscape. As of today, it’s still a question without an answer.
Whatever the outcome, the markets have clearly spoken in terms of what is expected. With more fiscal relief on the way, combined with the rollout of several vaccines, many investors are betting on a return to something much closer to normal in 2021. This collective view is reflected by the ongoing rotation from secular growers, like consumer staples, to cyclicals, like manufacturing, and a steeper yield curve (with longer term interest rates higher than shorter ones) driven by rising nominal and falling real rates. (Real rates are adjusted for inflation.)
I, for one, have been on board with the reflation narrative, even though I am agnostic on whether we will eventually start to see inflation. Any inflationary policy response to the crisis faces a large hurdle in terms of overcoming the deflationary forces of aging demographics and large debt loads. The burden of proof is on the inflationary policy, and, in my view, it’s still a relatively high hurdle.
After a partial recovery, what happens next?
My narrative since the COVID crash has been that the economy crashed from 100 (percent of capacity) to around 20 in Q2, and then recovered back to 70 in Q3, on the way back to 100 once the vaccines roll out in 2021 and the economy more fully reopens. It was all about the path from 70 back to 100, in terms of how smooth and how long or short it would be.
The market, being the discounting mechanism that it is, appears to have already priced in this favorable scenario. That means that it now has to actually happen for the market to be “right” and for equities to be correctly valued. If they are, all good, but if they aren’t, the market is out over its skis and there will need to be more policy action to extend that bridge to the other side of the abyss.
The main issue right now is that the high frequency economic data seems to have taken a turn for the worse. Below is Bloomberg’s daily activity indicator. Some countries are back to the spring lows as more and more of them have reinstituted some form of lockdown. This relapse in activity seems to be directly at odds with what the market is pricing in for 2021 and beyond.
Fortunately, other data paints a healthier picture. Below is the New York Fed’s weekly economic index, which continues to show some modest improvement. There also doesn’t seem to be any loss in momentum on the earnings estimate front.
We will see how the earnings progression unfolds in the coming weeks. For now, fingers crossed that, between the vaccine rollout and the recently passed fiscal relief, any current loss of economic activity is only temporary and that the reflation trade remains intact.