Despite a bout of heightened volatility at the end of January, most investors remain bullish on the outlook for the US stock market in 2021. After all, what could go wrong? If vaccine distribution reaches most of the population by late summer, we should expect an enormous boost in spending, as consumers return to the activities of normal economic life. In the meantime, the folks in Washington are working overtime to ensure that there is enough stimulus in the economy to get us from here to there. By instituting direct payments to struggling families and low interest loans to ailing businesses, the Federal Reserve and the US Congress are intent on minimizing the economic damage of this devastating disease.
In general, we share this optimistic outlook for a strong recovery in economic growth and corporate profits. With interest rates steady near historic lows, investors with bulging savings accounts (due to restrained spending during the pandemic) are deciding whether to lock in a negative real return on bonds or join the stock market’s rally. So far the choice has been easy.
No one likes spoiling a good party, but it is instructive to remember that the stock market doesn’t always fulfill the best of intentions. With the outlook appearing so rosy, it is possible, perhaps even likely, for the market to overshoot its fundamental value, setting the stage for a painful course correction. Signs of excessive optimism are apparent, as investors gravitate to so-called blank check companies (SPACs) with no operating history or even a cogent business plan.
Also, unforeseen conditions may emerge that derail that optimism. Among the most significant would be a serious setback in the administering of vaccines to fight COVID-19. Fortunately, Emergency Use Authorization (EUA) for Johnson & Johnson’s vaccine is expected in March, which will greatly expand the available supply. And distribution bottlenecks are slowly being addressed, allowing the pace of vaccine inoculation to steadily increase.
A sharp increase in the number of virus mutations that prove more resistant to existing vaccines would cast doubt on the second half recovery story that is the basis for the market’s recent buoyancy. So far, existing vaccines from Pfizer and Moderna have demonstrated effectiveness against the new mutations, but more research is needed in this area.
Some investors worry about the prospects for another sharp downturn in the economy before enough vaccine is distributed. Recent economic data has been surprisingly robust, despite ongoing restrictions in certain parts of the country. We view the likelihood of a double-dip recession, absent the vaccine-related risks described above, to be low.
Perhaps the most significant risk to the ongoing bull market in stocks is the possibility of a sharp rise in interest rates as a result of a sustained pickup in inflation. There are some warning signs already appearing. Inflation expectations (as measured by the difference between nominal and real treasury yields) have risen sharply. Crude oil prices have risen almost 50% in just the last three months, despite depressed demand. And even some liberal-leaning economists are warning about the inflationary impacts of the large stimulus package now being debated in Congress .
Inflation is subject to a constant push and pull of countervailing forces that make its direction difficult to predict. In general, we are more sanguine on the outlook for inflation and interest rates. After a temporary bump in the second quarter (caused by easy comparisons vs. last year’s depressed levels), we expect inflation to rise only slightly in the next year. There remain significant gaps (simplistically, the difference between actual economic activity and its potential) in both output and employment, which constrains price increases. While the economy is being flooded with liquidity through robust monetary and fiscal stimulus, banks have not been lending aggressively. Much of that liquidity is finding its way into higher asset prices, as evidenced by the steady gains in the stock market as well as broadly across residential real estate markets. The acceleration of innovation caused by the pandemic is improving productivity, which has a deflationary impact on prices. And finally, the Fed is committed to its purchase of long-dated treasuries and mortgage securities to keep interest rates low.
We are constructive on the outlook for stocks in 2021. But we encourage clients to emotionally inoculate themselves against a bout of market volatility, whenever it comes, by being mentally prepared, and employing an investment strategy that allows them to comfortably weather the storm.
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This report is the confidential work product of Ballentine Partners. Unauthorized distribution of this material is strictly prohibited. The information in this report is deemed to be reliable but has not been independently verified. Some of the conclusions in this report are intended to be generalizations. The specific circumstances of an individual’s situation may require advice that is different from that reflected in this report. Furthermore, the advice reflected in this report is based on our opinion, and our opinion may change as new information becomes available. Nothing in this presentation should be construed as an offer to sell or a solicitation of an offer to buy any securities. You should read the prospectus or offering memo before making any investment. You are solely responsible for any decision to invest in a private offering. The investment recommendations contained in this document may not prove to be profitable, and the actual performance of any investment may not be as favorable as the expectations that are expressed in this document. There is no guarantee that the past performance of any investment will continue in the future.
