Published on LiveWire 24/12/2020 (Original Article Here, subscription required) – Romano Sala Tenna
How do we see the outlook for 2021? Before I answer that question, I need to highlight a very important point: what follows is our current view. If something fundamentally changes tomorrow, then we will pivot and pivot rapidly. That is what we are paid to do.
So how do we see 2021 unfolding? Well, unlike many, we are not cautiously optimistic: We are, rather, outright bullish.
In fact, 2021 may well be the year 2020 was shaping up to be prior to Covid-19, except bigger and better due to the additional fiscal and monetary stimulus that has been added to the fire.
While we are tracking over a dozen ‘potential problems’, 2021 is looming as the perfect confluence of market drivers. There will continue to be noise and short term gyrations – and, yes, the market may be overbought in the short term – but we remain focused on 2 things: Liquidity and Necessity.
1. Central Banks globally have ‘printed’ more money more rapidly than at any time in history. Fact. Quantitative Easing (QE) – which began as an innovative but experimental way of saving the world from a global depression – has become mainstream. What began as a trickle in March 2009, has become a tsunami. Central Banks are not just willing to react with greater easing, but to be proactive and move ahead of the curve. All of this has provided a record injection into the financial system.
Even domestically, we have the most accommodative stance on record. The Reserve Bank of Australia (RBA) has engaged in quantitative easing for the first time since its formation. Repeat. The RBA has engaged in QE for the first time ever. Although not on the scale we have seen off-shore, this money- printing will still find its way out of bonds and into other asset classes such as equities.
2. The second driver of liquidity, is the rotation of capital from bonds to equities. Bond yields peaked in 1981 at around 16%. Since that time, bond yields have been in constant decline, generating the longest and most dramatic bull market on record. Whilst there is some debate around whether the bond bull market has finally ended, what is less ambiguous is that bond yields have little room to decline from the current level. This means that bond prices will struggle to rise and we will increasingly see the migration of capital out of bond funds into equity funds. And of course, new flows will be increasingly weighted towards equities.
3. Additionally, investors remain underweight equities and overweight cash from a historical perspective. The recovery in equities has not been embraced by wide sections of the investment community. Whilst an increasing number of investors are slowly ‘capitulating’ and adding to their weightings, we would expect that this still has some way to go.
It’s also worth considering the velocity of money, which in simple terms measures how quickly money is circulating around an economy (GDP/money supply). At present, through a high level of saving and a more cautious approach to spending (i.e. slower decision making), the velocity of money is at a level not seen since the 1970s. As confidence grows, the velocity will increase and assets (including equities) will rise as an ever-increasing money supply competes for a finite pool of assets.
1. Relative. The differential between cash rates/bond yields and equity yields is the highest on record. This differential far exceeds any rational application of equity risk premium. In a relative sense, advisers and investors alike have no alternative but to increasingly allocate to equities on a risk-adjusted basis.
We wrote about this earlier in the year and described it as the ‘great migration across the yield Serengeti’. The migration from cash and bonds to equities has perhaps never been more necessary from the perspective of relative yield. This migration is underway but has some way to play out. And the migration of capital between the three main asset classes is the most fundamentally powerful driver known to markets.
2. Absolute. Cash rates are the lowest on record with most major economies at or near 0%, with a number of nominal rates now negative. After deducting tax and inflation, the real yield is in the order of minus 2%. To state the obvious, advisers and investors alike will be forced to take on more risk to fund retirement and grow wealth. This will be reluctant at first, but inevitable in the end.
From an absolute perspective (ie even ignoring the relative attractiveness), equities provide the only solution versus cash and bonds.
At Katana, we often talk about cutting down the noise. The short term is noise and it is unknowable. The medium-term is determined by fundamental drivers. Whilst there are no certainties, we need to remain focused on probabilities, not possibilities. And, fundamentally, Liquidity and Necessity stack the odds very much in favour of equities at this juncture.