Remember a few short months ago when most assumed it would be years before the vaccine would be proven and distributed? I had no better idea of timing than the next guy, but I knew this was a ‘bet’ against human ingenuity – when countries or the world pour their brainpower and money into solving a problem, never bet against that. When JFK said they would put a man on the moon and set a hard deadline, you knew they would stop at nothing until that was achieved. This is a global episode of that type of challenge. There will inevitably be hiccups and challenges as we roll out the vaccine, but the market is looking past this for the most part as it’s a temporary issue in the long-term outlook.

Goldman Sachs economists expected half of the population of the U.S. and Canada likely to be vaccinated in April. They then forecasted the U.K. would vaccinate half of its population in March. They expected children under the age of 12 to start being inoculated in October 2021. One of the leading thought leaders on this subject in the US expects that between herd immunity and vaccination schedules, the US will largely be back to normal June/July 2021. Hopefully this plays out on that timeline, but we’re getting closer. But the near-term fear is that the second wave could cause economic shutdowns again, but it can be argued that this is unlikely to have a major effect on economic output like it did in the spring. Businesses are operating better now, the virus and its effects are better understood and not as fear-inducing, and social distancing rules are more targeted and not as widespread as they were in the spring. And remember, only a small subset of sectors is restricted currently – manufacturing, construction, education, etc are all running fairly normally now. And though the affected sectors are getting hit hard as we know, RBC Economics astutely points out that the combination of travel agencies, arts, entertainment & recreation, and accommodation & food services (hotels, restaurants and bars) only represented ~3% of the Canadian economy before the pandemic, where the combined output fell by more than half during the first wave. They have since recovered almost half of what they first lost, and even if they were to retreat all the way to their April low, it would only represent the subtraction of 0.7% from Canada’s GDP. Whereas the Canadian economy shrank by 18% in the spring, RBC Economics team believes it could well shrink by only 1% or so this fall, and the analysis is similar for the U.S. So, they anticipate a few months of stagnation/decline in U.S. and Canada, but not across even a full quarter. So, if correct, this analysis doesn’t support the view that economic shutdowns could cause a major pullback in markets.

There is ample evidence that the global economy is reflating. The copper/gold ratio and the more broadly based base metals/gold ratio are both surging, indicating cyclical strength. Earnings sentiment is improving in every region of the world. Other cyclical indicators, such as heavy truck sales, are turning up in a way that is consistent with an early cycle rebound. The consensus is that equites will be strong through much of next year, and is often reason to be cautious – but this is one of those few times that I would agree with current consensus on this point.

But There is Reason to be Near-Term Cautious

All that said, at current levels, the S&P 500 is essentially pricing in positive resolution of virtually all the major market influences (and ignoring some notable deteriorations) in my view. U.S. economic data is decent but the high-frequency readings (jobless claims, PMIs) are showing signs of a loss in momentum. Stimulus chatter is occurring, but nothing is actually happening as far as real money going into the economy. But, the market is forward looking, and the market has aggressively priced in positive incremental improvement across virtually every major market influence, and while that easily could occur, even if it does the short-term upside from here could be limited.

Some technicals are also starting to appear near term toppy. Investor positioning and sentiment does now appear short term stretched, with mutual fund equity exposures (i.e. “betas”) at highs, short interest at lows, and sentiment readings at highs. This could be a near-term headwind for performance:

All major markets trade at 10-year valuation highs on a 12-month forward price to earnings multiple:

And finally, this is always a good chart to check in on, and is one that Warren Buffett sometimes highlights. It shows the US market’s total valuation versus GDP - markets are trading at 1.8x GDP, which is about 30% above of the Dotcom peak:

One thing is sure, it "feels" nothing can move lower from here – and that in itself is reason to be cautious. So we prepare and position our portfolios for these risks as always, keeping some dry powder to deploy when the opportunity arises.

The Biggest Risk I See As We Move Into 2021 – In One Word: Inflation

Last week, market inflation expectations quietly surged to 18-month highs. And yesterday, for the first time since records were kept, real yields on corporate debt turned negative. We take both signals as early warnings that we need to watch 1) Inflation and 2) The rise in bond yields in 2021 closely, as both are risks to markets. A recent pop in inflation expectations, combined with relentless downward pressure on corporate yields, has created an environment where expected inflation (1.89%) is higher than the Bloomberg Barclays Average Investment Grade Yield (1.85%). That is a situation that frankly shouldn’t be, and I think it reflects the fact that the “bond bubble” just continues to spread across fixed-income securities and grow in size.

There’s not much talk about this, as bullish outlooks abound. And while I don’t disagree with the general consensus on this front, few are noting the risks to this outlook. The biggest risk to this bullish dream is a surprise spike in inflation, and as such we should be paying attention to what’s happening in the bond markets recently. Here’s why inflation could, almost single-handedly, destroy the bullish 2021 outlook:

1. Rising inflation would push bond yields higher, and as bond yields rose the market multiple would start to fall from the historically high 20x-22x to something more traditional like 17x-19x (depending on how quickly yields were rising). That would immediately take ~10%-20% off the S&P 500.
2. The real estate market, which is arguably the strongest part of the economy, would take a big hit as mortgage rates rose from the current historical lows.
3. Consumer spending would likely slow (possibly materially) as rates on virtually everything would rise: Car loans, personal loans, and credit cards. 

I understand anticipating the return of consumer price inflation and higher yields has tripped up many pundits for more than a decade. But I’ll also point out that we have never had a potential environment this conducive to sparking higher inflation (at least over my career and as far back as anything I can find). This is an environment that includes: massive ongoing quantitative easing (with no end in sight), promised 0% interest rates for years and years into the future, and historically massive looming fiscal stimulus (that dwarfs the package for the financial crisis). Additionally, due in part to years and years of historically low rates and global central banks pushing funds out the risk curve to find yields, we now have most highly rated government bonds providing solidly negative real yields, and now investment grade corporates providing a negative real yield. Of course, this can continue for quite some time, but at this point there is so much invested in fixed income funds that I actually shudder to think about what would happen if there was a stampede out of fixed income if inflation actually started to move even a bit (think 2013’s taper tantrum times 100).

I’m not advocating for massive portfolio shifts at this point, but we do need to be prepared and positioned. ‘Times are a-changin’, and your typical portfolio construction will not respond well to these events if unprepared. We are prepared.