The writer is president of Queens’ College, Cambridge university, and adviser to Allianz and Gramercy
What, if anything, will happen to the great disconnect between Wall Street and Main Street? This is a key question for investors positioning their portfolios for 2021. It is also an important question for the global economy and policymakers.
Throughout this pandemic year, we have experienced a further sharp widening of an already remarkable gap between financial markets and the economy. A rapid recovery in asset prices from the March 23 lows took major US indices to record levels, even before the recent good news on Covid-19 vaccines. Combined with even more accommodative central bank policies, this enabled record debt issuance at historically low levels of compensation for creditors.
Meanwhile, the global economic situation remains uncertain. Another coronavirus wave is sending parts of Europe back into recession. That is sapping energy out of the US recovery, and limiting the extent to which better performing east Asia can be a powerful locomotive of global growth. The longer this continues, the greater the risk of “scarring” that erodes longer term growth.
An uncertain economic outlook with notable dispersion among systemically important countries is but one of the key Covid-19 legacies that markets have set aside due to sky-high faith in central banks’ ability to shield asset prices from unfavourable influences. Markets being markets, investors have readily extended the protective nature of the umbrella to asset classes that, at best, are only indirectly supported by central bank funding (such as emerging markets). It is an extremely powerful dynamic, and one that inevitably overshoots.
Nothing is more reassuring to an investor than the knowledge that central banks, with much deeper pockets, will buy the securities they own — particularly when these buyers are willing to do so at any price and have unlimited patient capital. The rational investor response is not just to front-load their buying but also to look for related opportunities where return-seeking funds will be pushed to.
The result is not just seemingly endless liquidity-driven rallies regardless of fundamentals. It also alters market conditioning and inverts traditional cause and effect.
Based on what we know today, the challenges facing investors in 2021 are probably less about the first few weeks and more about later in the year. That is unless one or more disrupter is suddenly accelerated — a monetary policy reversal (highly unlikely), a market accident due to excessive risk taking (more likely but not overwhelmingly so), and mounting corporate bankruptcies (most probable but would play out over time). While investors will continue to surf a highly profitable liquidity wave for now, things are likely to get trickier as we get further into 2021.
Central banks’ deepening distortion of markets will be harder to defend in a recovering economy amid rising inflationary expectations. As welcomed as this recovery will be, it is unlikely to be sufficient to fully offset the impact of corporate bankruptcies or the detrimental effects of higher inequality. Investors might rue the day they ventured into asset classes far from their natural habitat that lack sufficient liquidity in a correction.
Navigating such a landscape will require analytical tools that would, ironically, have detracted from returns during the bulk of the liquidity-driven rally. I am thinking here of such things as highly granular credit and technical analyses, scenario planning, smart structuring, assessments of liquidity in market segments, and a better understanding of the extent of recoverability of investment mistakes. It also includes a willingness to re-examine some conventional wisdom. This involves rethinking the traditional portfolio construct of putting 60 per cent of funds into equities and 40 into fixed income now that yields on government bonds are so artificially depressed.
Already, the great disconnect has continued much longer than most expected. This illustrates, yet again, the unintended consequences of a policy approach that places an excessive burden on central banks. The hope for 2021 is that, with a vaccine-enabled economic recovery, better corporate fundamentals will start validating elevated asset prices and allow for an orderly rebalancing of the monetary-fiscal-structural policy mix. There are two risks, and not just for markets. First, what is desirable may not be politically feasible, and second, what has proven feasible is no longer sustainable.