Ticking off the milestones of an extraordinary financial year

Kevin Quinn

stocks

Drop: Traders work on the floor of the New York Stock Exchange in March last year. Photo: REUTERS/Lucas Jackson

April 11 2021 02:30 AM

March 23 marked a year since the low point in world stock markets. It’s hard to believe that a year has passed as we begin to emerge, slowly, from the pandemic.

If the drop that occurred in markets between February and March of last year was as fast as has been seen, then the recovery since this time last year has been extraordinary, with gains of around 60pc in world equities.

The past year in financial markets has had numerous milestones – central bank actions, vaccine announcements and huge changes in fiscal policy – each of them a turning point for markets. The initial recovery, led by central banks, saw both equities and bonds recover significantly through the summer months.

The clear winner back then was the IT sector, with high growth tech firms gaining massively from the ‘stay at home trade’ – rapid adoption of home working practices and from super low rates. Financials, real estate and energy were on the losing side but from November onwards they began to play catch up and financials and energy stocks significantly outperformed.

In recent weeks, the bond market took centre stage.What the bond market has to say about the world is hugely important and will ripple across all other assets.

In the past month, it has been vocal about what has been happening in the US. Hot on the heels of the election of President Biden, the new administration has succeeded in getting approval for a $1.9trn ‘American Rescue Plan’, ahead of seeking approval for a further $3trn ‘Build Back Better’ package.

What the bond market has to say about the world is hugely important and will ripple across all other assets.

Alongside this, expectations for economic growth have increased with the US Federal Reserve indicating it expects to see 6.5pc economic growth this year. Perhaps as a consequence, inflation expectations on both sides of the Atlantic have begun to rise and have reached pre-Covid levels (seven-year highs in the US). When economic growth rises, and inflation risks increase, central banks normally start hinting at nudging up interest rates.

Instead, the Fed has clearly indicated that it believes inflation will be transitory and it won’t be moving interest rates any time soon. It has very clearly laid out its intent to support full employment, while allowing inflation and the economy to run hotter.

The bond markets don’t agree and fret that once the inflation genie is out of the bottle it’s not going back in any time soon. Consequently markets believe that interest rates will increase sooner and as a result we are seeing longer term rates rising significantly. The key 10-year US bond yield has almost doubled from a low of 0.9pc in January to over 1.7pc at the end of March.

That inflation will be seen in the US later this year seems almost inevitable – the question is whether it remains elevated for a prolonged period.

These new dynamics, the so-called “Reflation trade”, present investors with a new set of questions, beyond Covid-19.

Will inflation be a short or longer-term challenge? Will rates continue to rise in the months ahead? Will central banks try to contain the market by exercising more control over longer dated interest rates? Are commodities at the start of a longer cycle of rising prices which will in turn feed into inflation?

These questions will feed into other markets, especially equities and will have a significant impact on how investors should think about the years ahead.
These changes have also been a catalyst to significant shifts in the equity market, with last year’s laggards becoming this year’s leaders. Indeed most of the dominant short-term trends in markets we are seeing today are simply the opposite of 2020. Financials, small caps and energy now lead where IT had been.

Kevin Quinn is chief investment strategist at Bank of Ireland