What could stop the rally?

Article #677 by Edward Rizzo - Published Weekly

Equity markets across the US continued to advance to new record levels during the first week of 2021 despite the significant increase in new COVID-19 cases around the world and the incredible scenes in Washington DC as a violent crowd broke into the US Capitol Building as part of the protests to overturn the result of the presidential election.

In recent weeks, many international analysts issued their outlooks for 2021 and there seems to be general consensus that the positive momentum dominating equity markets since the abrupt sell-off in March 2020 will continue throughout 2021 on the back of various favourable conditions.

Although COVID-19 cases have spiked again in various parts of the world, equity markets are clearly anticipating that the end of the pandemic is near and investors are thus positioning their portfolios accordingly to benefit from the ‘return to normality’. The expansionary fiscal policy measures being rolled out by many governments to ignite economic growth coupled with the historically low interest rate scenario are fuelling continued enthusiasm for equity markets.

But what could interrupt the continued rally across equity markets?

One of the factors that could dampen investor enthusiasm on the timing of the ‘return to normality’ is the pace of the vaccine rollout across the world. With governments issuing ambitious timelines to achieve what they believe to be ‘herd immunity’ among their population, the risk is that the rollout falls short of expectations partly due to the difficulties being encountered by the vaccine developers to supply the large quantities required and also due to the logistical issues in view of the temperature requirements for the transportation of both the Pfizer/BioNTech and also the Moderna vaccines.

Meanwhile, health authorities in various countries are reporting that patients are suffering from more virulent strains of COVID-19 which is forcing several countries in Europe to adopt stricter lockdowns and also for prolonged periods of time. Earlier this week, the UK’s chief medical expert claimed that the worst of the pandemic is still ahead with an alarming increase in cases expected in Britain leading to the health service entering a dangerous phase. The resurgence in the number of cases all across Europe and also the US, and the requirements for lockdowns, are bound to harm the world economy thereby prolonging the time for a recovery and possibly also the speed of the eventual rebound which was mainly anticipated to commence strongly during the second half of this year.

Since the low interest rate scenario is widely deemed to be among the most important contributors to the elevated valuations across a large part of the US equity market, one of the major risks to the continued rally would be an abrupt hike in interest rates. This may come about from the strong economic activity expected due to the pent-up demand in many sectors coupled with a surge in government spending which could stimulate a sharp rise in inflation rates. Although this scenario currently appears highly unlikely, a jump in real long-term interest rates worldwide could lead to a notable correction in equity markets. However, the major central banks will likely limit the rise in yields even as inflation expectations climb. This is supportive for the equity market which has historically struggled amid rising inflation.

The extraordinary policy response by all major governments worldwide triggered by COVID-19 was a key determinant of the sharp recovery in equity markets and the positive sentiment that quickly emerged following the onset of the pandemic. The ongoing fiscal and monetary policy support in 2021 will continue to sustain positive economic momentum as the rollout of the vaccines will then spur a post-pandemic economy. Another risk to equity market valuations would therefore be a withdrawal of the large-scale fiscal stimulus adopted across the US and other governments across the globe. However, so far, there is little sign that the stimulus programmes will come to an end. The USD900 billion fiscal package in the US passed after Christmas is expected to add two percentage points to GDP growth in 2021. Moreover, the loss of the Republican majority in the Senate may result in additional fiscal stimulus as yet another additional round of COVID stimulus will likely be one of the first priorities of President-elect Joe Biden. On the other hand, the 50:50 split in the Senate between the Democrats and the Republicans may lead to an erratic and slow process, as well as bipartisan compromise, on the approval of the more comprehensive legislative agenda of Joe Biden.

The pandemic led to a significant increase in the debt load of many capital-intensive companies which borrowed heavily at the start of the crisis. The higher leverage of these companies could eventually lead to higher rates of interest for such companies to issue further bonds in the future.

The bullish consensus among most financial analysts and investment banks is another factor that may cause some to be wary on what 2021 holds. Widespread general consensus often leads to euphoric sentiment and some commentators are comparing this situation to that experienced in 2018 as commentators at the start of that year were widely anticipating the rally to continue. However, during the final weeks of the year, equity markets had tumbled largely due to the sharp escalation in trade tensions between the US and China, as well as the breakdown in budget discussions between President Donald Trump and congressional Democrats which pushed the US government to the longest shutdown in history.

The various factors highlighted above that could interrupt the rally in the equity markets do not seem so alarming at this point in time according to many well-respected financial analysts and commentators. In fact, these columnists and finance professionals have all argued over recent weeks that current equity valuations may be warranted since interest rates are very low. Indeed, equities are attractively priced compared to the real yields offered on risk-free government bonds. Equities are therefore widely believed to be the favoured asset class and these should once again outperform bonds also in 2021.

The famous economist from Yale University who is widely known to have identified the equity market bubbles that burst in 2000 and 2008 and described that the best measure of market value is the cyclically adjusted price to earnings ratio, also recently remarked that equities are expected to outperform bonds for the foreseeable future.

In view of the current level of interest rates, stock markets are therefore not seen to be overvalued. The major determinant is therefore the level of interest rates going forward and the ability for companies across the globe to sustain higher earnings. The key question is whether real interest rates return to more normal levels at some point and when this could take place.

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Rizzo, Farrugia & Co. (Stockbrokers) Ltd, “RFC”, is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the company/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon.

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