Don’t fear the froth … yet

How long can this rally keep going? Vaccines, abundant liquidity, and improving data are supporting optimism. At the same time, a look at how far markets have come can’t help but give a feeling of vertigo. Many investors were under-allocated and missed out: buying now is hard. We argue that markets aren’t yet overbought, valuations are a poor guide to short term performance, and absent an external shock, there is room to run…for now.

After such a rally the main question investors are asking is: when is it time to sell? Investors that were underexposed to risk assets, or didn’t buy more cyclical assets in time to profit from the rotation we saw at the end of last year, are asking if they can buy now. How can an active, multi-asset investment portfolio adapt to this challenge?

The first question is to ask what key forces are driving the rally and will they be sustained? My team use a four-pillar framework to analyse macro forces across economic fundamentals, monetary & fiscal policy, investor sentiment, and valuation. Our core view as we start the year is that in the short term, this rally can be sustained, but we’re watching it carefully.

Fundamental indicators continue to point towards positive economic momentum. In the US, consumer data such as jobs numbers, credit card spending, and mobility tracking are holding up despite the surge in Covid-19 cases. Company surveys remain optimistic. The manufacturing sector is benefitting from low inventory levels following the 2020 crisis, leading to high current production. In the short term there is a concern that the surge in Covid-19 cases may lead to stricter lockdowns from President Biden or Chancellor Merkel, but the medium-term picture is healthy.

Strong fundamentals are supported by incredibly easy monetary and fiscal policy. As we’ve argued in more detail elsewhere , the results of the Federal Reserve’s policy review last year herald the most important change in central banking since the 1970s. The Fed and others will no longer attempt to pre-empt inflation with aggressive measures to tighten financial conditions but will instead let economies run hotter until inflation is proved. This means in our view that monetary policy will stay loose for most if not all of 2021, and talk of early Fed tapering is unlikely.

On top of this, President Biden has already announced his intention to seek an enormous fiscal package: while his ambitious plans will almost be certainly watered down as they pass through the US political process, the final package will be meaningful. Elsewhere, there is a consensus that the austerity of the post-global financial crisis was a mistake, and the appetite for public spending remains strong. The key for investors is which exchequers are likely to remove stimulus first, and what that means for regional allocation decisions.

Of our other two pillars, our research tells us that valuations are not a useful guide for short term returns, so are of less importance at this stage. Market sentiment is perhaps where we are spending most of our time, looking for signs that there’s too much froth in markets. We use a range of different leading indicators to show investor positioning. Our current view is that while of course investors have become more bullish in recent months, we are not yet at a stage where we are overly concerned. While market volatility has come down a long way, the VIX Index is just under ten points higher than it was this time last year and downside protection remains unusually expensive reflecting a degree of caution among investors.

Our conclusion is that while we are increasingly concerned about sentiment measures, absent an external shock there is room to go in this rally and it’s not yet time to head for the door. While it’s always difficult to make predictions of what might happen in six months’ time, our expectation is that the rally will run out of steam towards the middle of this year. Economic growth is still recovering from the crisis period, and growth momentum will naturally flag as we move towards the third quarter. After passing a large stimulus package, the Biden administration’s attention will turn towards balancing the books, and tax increases are likely – in the US and elsewhere. This will likely coincide with the Fed increasing talk of reducing monetary accommodation, by tapering asset purchases in 2022 rather than rate hikes.

The rally can’t go on for ever, but it can go on for a while yet.