by Kevin McCreadie, CEO, CIO, AGF Management Ltd.
Equity markets are churning higher, but euphoric investors beware, says AGF’s CEO and Chief Investment Officer. Irrational exuberance has a way of ending badly when left unchecked.
Equity markets continue to rise at an extraordinary pace. Can they keep it up throughout 2021?
There are good fundamental reasons to believe equity markets will end this year higher than they were going into it. This includes the idea that large swaths of the global population will be vaccinated against the COVID-19 virus and that some semblance of economic normalcy will return as that happens, but also the fact that governments and central banks around the world seem dead set on continuing to support the economy and markets with whatever stimulus is needed until such time everything does return to normal. In doing so, investors are being given the confidence to look beyond present-day circumstances – as dire as they may be – and make decisions based on what will likely happen and not on what is now happening. And this makes sense to some extent. Remember, markets are forward-looking and there is a tremendous amount of pent-up demand for future spending, not to mention a degree of pent-up savings not seen in years. U.S. bank deposits, for instance, are up close to 30% year-over-year by some estimates, in large part because people who have continued to work throughout the pandemic have had less opportunity to spend their income as a result of the ongoing lockdowns and restrictions on economic activity. If anything, we’re already seeing some of that savings seep into markets, which helps partially explain the rise in stocks to date, but even more of it will be put to work post-pandemic either directly through further investment or indirectly as normal spending habits on goods and services resume and stoke corporate earnings expectations further.
Is there a danger that investors have become too bullish?
That may be the biggest concern right now. It’s one thing for the market to anticipate an economic recovery, but so much has been priced in already and sentiment has become so one-sided that there are now pockets of froth in the market that are bound to create more volatility going forward as they get wringed out. Think of Bitcoin, which now trades close to US$40,000 and has risen 26% since the beginning of the new year, and more than 320% since before the pandemic. Or what about all the U.S. university students on TikTok talking about how they are going to invest their US$600 government support payment in this stock or that stock? And then there’s the story of mistaken identity related to comments made by Elon Musk recently. It’s hard to fathom how a company sharing the same name as the one he was promoting can rise more than 2,000% in just a couple of days even when it’s clear there’s no other connection between them. In fact, their business models are not even remotely related to each other. So, all of this is evidence of a growing excess that taken together is very reminiscent of the euphoria and irrational exuberance that preceded the Tech Wreck in the early 2000s. That’s not say we’re heading for another major bear market correction, but it’s more than reasonable to expect stretches over the next few weeks and months when equities and other risk assets experience large pullbacks as these excesses ultimately become untenable.
Beyond these excesses, are there other potential risks that may not be fully appreciated?
Investors should keep an eye on bond yields. The 10-year U.S. Treasury yield has climbed substantially in recent weeks and while the current level isn’t that much of a concern, the pace of the increase could end up being a headwind for stocks if it continues at the same clip. Inflation, moreover, could end up being a reality as soon as the second half of the year. While The U.S. Federal Reserve has signalled its willingness to leave interest rates untouched for the next couple of years even if consumer prices run a bit hotter than its 2% target, that was before the new White House administration announced its plans to spend an additional US$2-trillion and it could be dangerous to assume the Fed won’t necessarily hike rates if inflation rises more aggressively than anticipated. Short of that, we also may be underestimating the political discord we are seeing in the United States. It’s confounding that stocks were up on the day the U.S. Capitol was under siege earlier this month and that government bonds, a traditional safe-haven asset, sold off. Perhaps it’s yet another example of market excess, but investors can’t ignore the potential for more turmoil ahead. After all, swearing in Joe Biden as the country’s next President doesn’t change the fact that a significant percentage of the American population still consider Donald Trump their party’s de facto leader. Nor will it deter the new administration from pursuing an aggressive agenda on re-regulation and higher taxes which could be headwinds as the year progresses.
Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Limited. He is a regular contributor to AGF Perspectives.