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We have made it to Christmas 2020 and what a year it has been. Markets have recovered from March lows even though everyone in the world can see economic problems today (lockdowns, unemployment, businesses closing) and uncertainties and challenges ahead (economic scarring, debt, matched against changed consumer and corporate behaviour). How have markets achieved these levels, you may ask? The key is that risk premiums have been squashed and the risk-free rate is close to zero and in real terms is -1% in the US. The risk-free rate is simply the return you can expect for holding the theoretical lowest risk investment over a period of time. Markets generally assume this to be Treasury Bonds, with the current rate of inflation deducted to give you the real return.
This anomaly is purely the result of quantitative easing and interest rate policies that have challenged the effective floor of risk-free rates. If the risk-free rate is the foundation for valuing all other financial assets, then when it is repressed, the risk-premiums on other assets are repressed. Private investors have been crowded out of risk-free assets (government bonds) and have been forced to take on more risk as a result. You can only get real long-term growth in income from equities when bond yields are this low and the demand for that earnings stream has increased, pushing up equity prices. Even bombed out assets are coming back, now that the left-tail of credit events has been cut off by central banks and the path to increased activity in travel, hospitality, retail and real estate has been partially cleared by the vaccine news.
The biggest protracted risk to markets going forward is not necessarily weaker growth or disappointment on the efficacy of and take-up rates of the vaccine – although these would be negative forces – but it would be the readjustment to higher risk premiums. Higher risk premiums would come from central banks backing away from financial repression. Are they going to? No, it is very unlikely that they do in the year ahead. The stance of the major central banks is well known. No rate hikes. Limited reversal of balance sheet policies. The continued provision of liquidity facilities. If the economy gets bad, the central banks will just turn the taps on again. Inflation moving high enough to cause a significant change in monetary policy is very unlikely in the next few years, apart from a short-term rise in the Spring due to the year-on-year effect of energy price rises. Moreover, given where government debt levels are, why would central banks want to let bond yields rise? Amongst policy makers there is broad consensus that fiscal policy has to be used to support the economic recovery and central bankers will do their best to keep borrowing costs down. The 10-year Portuguese government bond yield turned negative this week. What more evidence do we need about repressed risk-premiums and the willingness of the global investment community to adapt to that world?
Do not panic, we are not being totally overtaken by Christmas optimism, there will indeed be periods of volatility and market weakness ahead. However, much as we have done in 2020, we stand ready to take advantage of any short-term market drops and keep building our portfolios for our patient, longer term investors. We thank you for this patience and we hope that ultimately it has been rewarded after keeping calm in the March market collapse.
The themes that will determine the narrative in 2021 seem obvious, yet we do not know quite how they will play out yet. We also must not be complacent, there is always something lurking out there that we do not yet know about. The US has to get through the drama of the transition and see Donald Trump leave the White House and then to see what policy initiatives the Biden Administration can act on quickly. The central view is that any stimulus package being discussed right now in Washington will be followed by a bigger one next year, with a broader range of ambitions – many of them climate change related. In the European Area, it is a similar picture with the enactment of the multi-year budget process and the ability of countries to cope with whatever Brexit we are going to be served up. All of this adds up to fiscal stimulus – although not quite as high-powered as in the US. The UK narrative will be how the deal or no-deal plays out for the UK economy and whether the Johnson government can start on a path of fiscal retrenchment. I doubt it personally given domestic politics and the need for the Conservatives to retain the goodwill they were given at last December’s election. Buying UK assets could be one of the trades of next year if the uncertainty is lifted but there is the danger of a value trap if it turns out that the new arrangement is, at the margin, worse for the UK than what would have been the case if it had remained in the EU. As we have written for the last six months, we still see Asia as a good play for both equities and fixed income given stronger growth, less scarring from the pandemic and higher yields.
This will be my last communication before the Christmas break, so I will now bid you a very Merry Christmas and wish you a brighter and healthier New Year. Stay safe and well and thank you from all of us here for the trust you have placed in us to look after your wealth. It has been a very challenging year for everyone here and for you all at home. I do hope we have come through it stronger for the challenge and we are very grateful for your continued support.