Lessons From The Last Year: V-Shapes And Regime Shifts
March 25, 2021
Ask Forstrong: The stock market is up strongly since its COVID bottom. What happens next?
Stock markets have rebounded strongly over the last year. But it would be a mistake to assume we are back to “where we were” pre-pandemic. The macro outlook has completely changed.
Most importantly, coronavirus has reset the economic cycle and provided powerful policy breakthroughs.
The world’s ongoing thirst for government largesse will be the pandemic’s lasting legacy. Expect “high pressure” economics to persist well into the future.
Yet expectations for investment returns have become higher. We are now entering the next phase of the bull market where underlying fundamentals must deliver to keep the party going.
This week marks the one-year anniversary of the global stock market bottom. The descent goes down in history as the fastest ever market downturn — a hair-raising, five-week 35 percentage point freefall. Remember it? Of course you do.
A year ago, few people forecast an equally powerful symmetry on the upside. Yet here we are. Global stocks have notched new highs. Commodity prices have soared. And that familiar sighting in financial markets — animal spirits — are alive and once again coursing through credit markets. High yield bond spreads have now made a near-perfect round trip, sitting at pre-pandemic lows. What’s more, the possibility that broader vaccine distribution will lead to herd immunity by the end of the year is no longer fanciful. And, not to forget the kids, Disneyland is set to re-open.
Looking back, some investors may feel whiplash and broad confusion. The coronavirus, when it came, did not hold back. Cases surged and humanity was swiftly locked down. The World Health Organization’s declaration of the virus outbreak as a pandemic was an important demarcation line in the public consciousness. Suddenly, it was not just Milan or Wuhan’s issue but the entire world’s problem too. Everyone got the memo.
Stock market bottoms are entirely different. No one issues a press release to herald their arrival. No bells are rung. No buntings are hung. The investment community, rather than leaning in further, is often caught flat footed, wobbling and scrambling to pre-empt client concerns and, in the lingua franca of corporate communications, get “out front”.
To be fair, Forstrong too, was trying to get out front last year. Near the bottom, our investment team issued several client reports, each with the same message: the economic downturn triggered by COVID is a transitory shock rather the typical recession driven by monetary tightening or a credit crunch.
Many are still misreading this, mistaking the coronavirus crisis for another 1999 or 2008. It is not. This is because the terrain upon which the virus landed is far different. No major global imbalances existed in early 2020. In fact, most imbalances had largely been worked out in the post-2008 crisis period. That meant, should the threat of the virus recede (as it is now), the cyclical rebound would be immediate and explosive.
As it was, COVID was always an unlikely catalyst to a longer-running downturn. In an Ask Forstrong report entitled Investing In the Time Of Coronavirus issued on March 26th 2020 (three days after raising risk to the near-highest levels within client portfolio constructs), we wrote:
Fear, that wild and foreboding thing that has settled over all of us, is not a sentiment to be wasted. In fact, in the world of managing money it is essential to outperform. Investors must act now. We are.
Of course, no one knows where the bottom may lie. But we do know that the conditions for a meaningful rally are here. This liberates us from trying to call the exact bottom and instead align client portfolios with the various risk and return tradeoffs available across capital markets.
About That V-Shape…
Since then, Forstrong strategies have handily outperformed benchmarks. We do not mention this to take a victory lap, but rather to highlight forward-looking markets at work. Why were we bullish? Not because we believed the outlook was good. The entire world knew growth and earnings would collapse. Rather, we were constructive on risk because our behavioral investment process revealed universal pessimism. Upside surprises would become easier to deliver. Worst case scenarios were already priced in and policymakers were enacting war-time fiscal and monetary responses.
One year later, our investment team has again concluded another quarterly investment meeting (marking this author’s 72nd such occasion, comprising more than 700 investment sessions). What has changed over the last year? First, for full disclosure, a few of us could use a haircut and a beard trim (in recent Zoom calls, many colleagues are starting to look less like Leo in The Wolf Of Wall Street and more like him in The Revenant). Still, minds were sharp, and the focus was squarely on the period ahead.
At that start of each session, our team identifies any emerging consensus views. One taking shape is that, with markets back to old highs, the investment outlook is essentially back to “where we were” pre-coronavirus. This view will almost certainly turn out to be wrong. In late 2019, markets were indeed in a late-stage cycle. The economy was near peak employment. Yield curves were flat. With weak earnings growth projections, corporate profit margins looked to be peaking. And, several central bank officials, not least many at the Fed, were forecasting rate hikes in 2021.
The coronavirus crisis changed everything. First, it reset the clock on the economic cycle. We are now in the early to mid-stages of a cyclical upswing. Secondly, the crisis paved the way for policy breakthroughs around the world. In fact, last year was a moment of revolutionary breakaway from austerity and deficit shaming. Both are now dead.
It would be unusual if these radical policies did not continue for a long time. Consider the behavioral aspect. When civilization is confronted with mass suffering, it is natural, and even comforting, to believe that we will emerge with more insight about the best way to manage our economies and societies. A tragedy without a corresponding reform agenda is simply too difficult for humans to even contemplate. The alternative is to accept the role of randomness in life. Human brains are just not wired that way.
Calling The Late 1960s: The Return Of High Pressure Economics
Looking ahead, growth will come roaring back as economies are unlocked. But the key question is what governments will do to alter the rules of the game after economies return to trend growth. What is now abundantly clear is that the world’s ongoing thirst for government largesse will be the pandemic’s lasting legacy.
Many economists now fault fiscal austerity and premature monetary tightening for the economy’s slow-moving recovery from the 2008 global financial crisis. It took until 2017 for the US employment rate to return to its pre-crisis level, making it the most drawn out rebound since the mid-nineteenth century. Obama’s recent memoir even attributes his 2010 mid-term election loss on the slow job recovery. On top of that, widening wealth skews, stagnant wages (which have languished for 40 years in the West), weak capital investment and fledgling productivity growth are widely blamed on previous policies.
Now, governments have a historic opening, even a chance to reverse the sting of populism. Will they seize on a game-changing economic agenda? Without question. After the recent passing of $1.9 trillion in COVID relief legislation, the US government has now spent U$5 trillion on support measures over the last year. Unfazed by any inflationary or overheating risk, the Biden administrating is now rapidly planning another massive package directed at public investment.
It is easy to see what is happening. In fact, what is new is old here. The term “high pressure economics” has moved swiftly back into today’s lexicon. Originally popularized in the late 1960s by Arthur Okun, chairman of the Council of Economic Advisers during the Lyndon Johnson administration, the concept is simple: aim to push GDP growth above its potential and unemployment below the natural rate. What should follow is that companies raise wages to attract and retain workers. To offset increased labor costs, firms would need to focus on boosting productivity. All of this should shrink income gaps, upgrade the labor force and increase innovation.
That’s the theory anyway. Over the long term, it really doesn’t matter if it works (isn’t economic theory fun?). What matters is that deficits and growth will be higher over the medium term. And central bankers will support it all the way. Powell was practically carried out of his last press conference on the market’s shoulders with this statement:
“A strong labor market that is sustained for an extended period can deliver substantial economic and social benefits, including higher employment and income levels, improved and expanded job opportunities, narrower economic disparities, and healing of the entrenched damage inflicted by past recessions on individuals’ economic and personal well-being. At present, we are a long way from such a labor market.”
What can be said about the last year? Markets have risen but many of us are simply homesick for a world that no longer exists. And, we are caught in that awkward space between lockdown and re-opening … waiting for a black and white moment to burst into color.
Investment markets are in a similar spot. They are always priced on the interplay between expectations and reality. One year ago, expectations were dismally low. Today, more optimistic outlooks have radically re-priced risk upward. That means we are transitioning to the next stage of a bull market. The first phase backed us away from the edge of the abyss. The second phase must see improving fundamentals to keep the party going.
The transition will be bumpy. This week, the bull market slipped and was offered a glimpse of its own mortality. Yet the bigger story for investors continues to be a regime change in worldwide macroeconomic policies. Low pressure economics of the last decade are over. In the new paradigm, investments tied to broader global growth will continue outperforming as they have in 2021. That means a generally weak US dollar, persistent strong growth in Asia and a continuing tailwind for value over growth. All of these trends are still spring-loaded to last for years.
Performance statistics are calculated from documented actual investment strategies as set by Forstrong’s Investment Committee and applied to its portfolios mandates, and are intended to provide an approximation of composite results for separately managed accounts. Actual performance of individual separate accounts may vary with average gross “composite” performance statistics presented here due to client-specific portfolio differences with respect to size, inflow/outflow history, and inception dates, as well as intra-day market volatilities versus daily closing prices. Performance numbers are net of total ETF expense ratios and custody fees, but before withholding taxes, transaction costs and other investment management and advisor fees. Past investment results provide no indication of future performance. Future returns are dependent on the general investment environment, the nature of the investment mandate and specific portfolio risks. A rate of return for one year or less is not annualized.