Ever since March, stock markets have existed in a sort of ‘neverworld’, propped up by huge Central Bank and Government support and so able to ignore the dreadful economic news in hope of better times ahead. When hope shone ever brighter last quarter with the announcements of the vaccines, markets responded appropriately.
The key to the markets insouciance has been Central Banks anchoring interest rates at near zero and signalling that this will be case for years to come. This means that future returns on assets like cash and government bonds will be virtually zero forcing investors into higher risk/reward assets like equities. This cannot be overemphasised. It also has two other less intuitive but equally important effects. Lower interest rates allow for higher stock market valuations because stocks don’t have to produce such high returns with bond yields so low (lower required earnings yield, the inverse of the P/E ratio for you investment pros out there). In other words, while equity markets may historically look ‘overvalued’, in reality the unprecedently low ‘risk free’ rate makes them less so. Secondly, lower interest rates increase the discounted present value of future cash flows, again making stocks look ‘cheaper’, particularly growth stocks with significant multi-decade earnings expectations. This all sounds a bit theoretical so let’s jump to the punch line – low interest rates are a huge support to equity markets. There is a corollary; if interest rates start to rise then all the above will unwind and be a headwind not a tailwind. As noted above, it could also lead to a big reversal in the growth over value style trend that has dominated markets for a decade.
The other pillar to the surprisingly strong equity markets of last year was the belief that along with a relatively robust economic recovery in 2021 the corporate world would be innovative and resilient in the face of the pandemic. This is of course very industry specific, an open goal for technology and e-commerce but a catastrophe for high street retail, leisure and travel. Nevertheless, in aggregate, earnings have held up better than expected and forecasts for this year look strong and a major determinant of equity market returns this year will be these forecasts being met. Current forecasts are for global earnings to have fallen by something like 20% last year but to rebound strongly by 25% in 2021. The biggest rebounds are in the geographies where earnings have been most hit like UK, Europe and some of the Emerging Markets. Earnings in the US have been helped in aggregate by strong numbers form the technology sector and are forecast to have fallen by 14% in 2020 with a rebound of 22% this year.