Two Quiet Clues To 2021 Market Direction

Rick Rieder and team highlight two recent publications that might prove instructive for portfolios in 2021.

The last several weeks of 2020 provided abundant drama; an election, a second wave of Covid pandemic spread, a vaccine rollout and another strain of the virus to worry about, which even if not out of character for that tumultuous year, has certainly kept the markets and media occupied. Still, two other important events quietly took place amid the eventful holiday season, and both coincidentally hit the press on November 30.

The first was the release of a research publication by economists Jason Furman and Larry Summers, which argued that developed economies have the fiscal capacity, and hence perhaps the fiscal responsibility, to do more to create sustainable long term growth trajectories. The second event was an update that Yale University Professor Robert Shiller made to his widely followed Cyclically Adjusted Price Earnings (CAPE) equity valuation model; adding a new variable to account for changes in discount rates. We think that understanding the implications of both these publications may prove to be just as important in providing clues to 2021 market direction, as will unraveling the twists and turns of the U.S. election landscape, or the path of the global pandemic.

Debt, Deficits and the Boost of Fiscal Policy

We have long argued that monetized fiscal deficits and rising debt levels on their own are insufficient evidence of economic malaise, especially for countries that issue reserve currencies. Much more important is what incremental debt is being used for, and the sustainability of the cash flows that support it. Furman and Summers follow a similar line of reasoning by saying that lackluster growth and inflation in developed markets may be boosted by targeted fiscal spending. Over long horizons, the cash flows that accrue from productive investments render the debt incurred to fund them as sustainable (the orange bars in the first graph).

Debt as a Percentage of Current and Infinite Horizon GDP

Our conclusion for portfolios? Once the economy has recovered from the pandemic (we think it will in 2021), if long term nominal growth and productivity-enhancing projects are going to be increasingly sought after as targets for new government spending (as we argued they should be in our commentary entitled The Policy Liquidity Monopoly), then the asset allocation implications favor the bottom of the capital stack (namely, equities and spread products), as opposed to the top (risk free rates).

The Significance of a Real Model Adjustment

On the same day that Furman and Summers published their research, Robert Shiller published a significant update to his widely followed CAPE model: he subtracted the real yield on U.S. Treasuries (in other words, the yield on U.S. TIPS) from the reciprocal of the CAPE ratio to show what an equity investor could expect to earn over risk free bonds, in real terms, based on market pricing. The simple CAPE ratio made equities look expensive in price terms (left-hand graph in the second chart). But when adjusted for the real yield of risk-free bonds, equities appear reasonable relative to history in excess yield terms (graph on the right).

CAPE model ratio

We have long argued for the same adjustment when valuing equities, most recently in our commentary Taking stock: 11 themes to consider as we look toward 2021, in which the equity risk premium features prominently. It is imperative that equity investors understand the earnings potential of companies in their portfolio, as well as the price they are paying for those earnings. But it is equally important to understand the rate at which future earnings are being discounted, in order to evaluate the true attractiveness (or unattractiveness) of that price.

Portfolios Need to Keep Flexible to Pivot With Changing Conditions

Just south of the city-state of Singapore lies a tiny but tranquil resort island. Today it is called Sentosa (a Malay name meaning “peaceful”), the result of a 1972 name change. But in the years before that it had the more unflattering name of Pulau Belakang Mati - “Island of Death from Behind” (again translated from the native language of Malay). Rumors abound as to how it got that name, but one of the most recent myths surrounding it are that in World War II, British troops had pointed their artillery at the open sea, where they expected the Japanese army to attack from. Instead, the Japanese army had attacked from the mainland (from “behind”), through Malaya. According to legend, the British cannons did not have a wide enough turning circle to re-orient themselves, eventually resulting in a failed defense and surrender to the Japanese (the original British fort on Sentosa along with its cannons are now a tourist attraction).

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Similarly, a singular focus on debt, or on Debt as a % of Current GDP (the rising blue line in the first graph), or the unadjusted CAPE ratio (the left-hand graph in the second figure), could prove to be red herrings. Investors that are overly focused on these metrics and draw risk-averse conclusions from them may not be able to re-orient portfolios effectively, should the perceived negative economic outcomes be avoided. There is still a great deal of uncertainty surrounding economic and market outcomes, at the very least as measured by the VIX, which remains above its post-GFC average. Hence, the portfolio of 2021 needs to be dynamic and flexible enough to pivot wherever market and economic clues are leading. Today, we think there are two more clues that are pointing toward a more reflationary outcome in 2021.

Rick Rieder
Rick Rieder
Managing Director
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is Head of the Global Allocation Investment Team.
Russell Brownback
Managing Director
Russell Brownback, Managing Director, is Head of Global Macro positioning for Fixed Income.
Trevor Slaven
Managing Director
Trevor Slaven, Director, is a portfolio manager on BlackRock’s Global Fixed Income team and is also the Head of Macro Research for Fundamental Fixed Income.
Navin Saigal
Navin Saigal, Director, is a portfolio manager and research analyst on BlackRock’s Credit Enhanced Strategies team.

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