22 February 2021.

While the US Presidential election ushered in a new administration, the global surge in COVID-19 infections continued unabated. Despite this, the markets elected to focus on a brighter outlook, premised on the rollout out of COVID-19 vaccines and promises of further stimulatory measures by US President Biden leading to upward revisions to economic growth forecasts for the end of 2021.

With central banks and government agencies the world over pledging ongoing financial market support, equity markets took their cue to surge across the quarter, pushing through record highs, with global equities up 9.8%. Australia posted an enviable scorecard on both pandemic performance and economic recovery. Australian equities posted extraordinary double digit gains (13.8%) off the back of effective pandemic measures, signs of resilient retail sales data, improving unemployment figures, strong commodity prices, a buoyant property market and strong Reserve Bank signals that interest rates are to stay lower for longer.

Meanwhile, in something of a contrary signal to that posted by the ebullient equity markets, interest rates continued to grind lower over the quarter as the Reserve Bank of Australia (RBA) provided further economic stimulus by cutting all 3 key interest rates, including the cash rate target, Term Funding Facility (TFF) rate and the 3 year government bond yield target from 0.25% to 0.10%. They also embarked on a formal quantitative easing program to increase money supply and keep rates low that involves buying $100 billion of government and semi-government bonds to lower longer dated interest rates.

By the end of the quarter, it looks as though most of the positive news has now been fully appreciated by the markets. Signs that the ever lower interest rate cycle may have reached its end in the USA has seen enthusiasm for equities tempered somewhat as we enter the New Year. As we head further into 2021, ongoing prudence will be necessary to guide careful investment decisions.

A fork in the road

With equities, both domestic and international, looking expensive, and yield curves threatening to at least steepen to raise long term interest rates, the question remains: should investors continue to ride the equity market rally or seek a defensive position in the face of expensive valuations and overly bullish sentiment?

The market is pretty well divided at this point, veering between the positive view based on momentum and liquidity against excuses for a correction. The threat of the liquidity driven bubble bursting forms part of the wider debate as to whether the markets are on a major inflection point to end the spectacular cyclical/secular bull markets of equities/bonds.

In the short term, the momentum argument, aka FOMO (fear of missing out) or TINA, (there is no alternative) is difficult to refute as the equities market continues to press ahead. A liquidity driven bubble is hardly surprising given the explosive growth in M2: a calculation of money supply including cash, checking/savings deposits, money market securities and mutual funds (see chart 1). This goes a long way to explaining the continued buying of equities while interest rates are so low – what alternative is there for investors chasing a return?

Chart 1: US M2 Money Supply v’s S&P 500 equities index. Source: FactSet

Contrary to the positive outlook, there are plenty of arguments to suggest a more cautious stance is warranted, based on three key observations:

1. Rotation out of pandemic-driven economic disappointment;

While a slow roll-out of the COVID-19 vaccine and the introduction of mutant strains may delay recovery, the end game remains the same: widespread inoculation with effective vaccines. With last year’s stimulus still coursing through the global economy, the fiscal response this time around may well be far smaller. It also appears that the economy and business is becoming more adept in coping with the pandemic restrictions. While it started with a very strong correlation, the impact of lockdowns on economic growth is now less evident (see chart 2).

Chart 2 Source: FactSet

2. The risk of an inflation induced bond sell-off

Little on the data front suggests inflation is on the turn. The US Federal Reserve’s new Average Inflation Target Regime will allow some latitude so it is unlikely that an imminent threat of inflation will be the driver for a correction. However something is at play. The US 10 year treasury (global risk free proxy) yield, having risen from a low of 0.51% on 4 Aug 20 is currently 1.11% - expectations are now shifting.

3. Impact of increased mega-tech regulation

The impact of a curb to the FAANGM (Facebook, Apple, Amazon, Netflix, Google and Microsoft) stocks cannot be underestimated as they now account for a staggering 24% of the S&P 500 market capitalisation and around 10% of global developed market capitalisation. However, it appears tech regulation is not at the top of the Biden agenda and while currently expensive, the ongoing strong growth amongst these companies is likely to be bolstered by the emergence of synchronised global growth.

Understanding sentiment remains the key

The bearish argument may be best served through a focus on sentiment, one of the more telling indicators at a time when fundamental factors (valuations) appear to carry less weight as a market tool.

Investor complacency is evident across a number of fronts. The rise of the SPACs, (special purpose acquisition vehicles) smells very much like the proliferation of cash box companies that preceded the 1987 share market crash. Speculative retail investor activity in leveraged instruments and high risk trading strategies as recently witnessed in the GameStop play, signals a high level of risk taking and scope for massive disappointment.

Such speculative fervour may not end the bull market however it may well engineer a decent pullback in the market that looks well overdue.

Our approach

Having been bearish through 2020, we were well positioned for the overheated market to correct which it duly did in March. While we retained a defensive allocation throughout the remainder of 2020, we began moving towards a neutral position through the last quarter. On the back of a solid rally over the December quarter, which further pushed investor sentiment and valuations into elevated highs, we have once again elected to hold a more defensive stance.

With an explosive +13.8% returns from Australian equities over the last quarter, the perils of being caught short in a rampant equity bull market remain obvious. Conversely, when the tide does turn, the dangers of not protecting capital, in the face of an era that will inevitably generate below long-term trend returns, looms ever larger.