Are we going to party like it’s 1999?

Often in our year-end piece, we have summarized the year that was. As 2020 is the year that many would like to forget, this year rather than looking backward we will focus almost exclusively forward. So, if you have an old Prince CD around or can stream something from Spotify, we will dance our way through a few reminisces of the late 1990’s and the current parallels.

A compelling case can be made for continued strength in equity markets. When we cut through the rhetoric, financial markets are about money, and there is no shortage of money being pressed into the system. It is coming from every direction. To paraphrase the Prince song alluded to in our title…the sky was all green, there was money flying everywhere….

Central banks have been printing money to support the financial system and fund government debt – although the Bank of Canada will tell you this is an accidental by-product of policy. Although the pace of new money growth is expected to slow in 2021, it is not expected to reverse itself until at least 2022. Central bankers have guided to 2023 before short-term interest rates are likely to be moved higher. When we examine the scale of intervention, the U.S. Federal Reserve and European Central Bank garner most of the attention, but when scaled to the size of the economy, the Bank of Canada’s actions have exceeded those of the larger central banks.

Fiscal policy has been equally generous, with an additional $900 billion stimulus package being passed by the U.S. just before Christmas. The Canadian government budget deficit is expected to leap past $300 billion this year. Household incomes have increased significantly due to the various subsidy and supplemental income programs put in place. Household savings rates have also risen.

As vaccines roll out across the population in 2021, people may emerge from their bunkers and begin spending. The pace at which individuals begin to re-engage in normal social activities is still to be determined, with some expecting a quick return and others a delayed return. Based on our conversations with clients and others we expect the return to normal will be a progression over many months. While some people are anxious to reclaim their previous lives as soon as possible, others remain more cautious.

The fiscal programs that have kept households afloat will likely wind down slowly, with the pace determined by the stickiness of unemployment and the rate of economic recovery. This phasing out of income support programs may be offset by other government spending as many countries focus on using the virus recovery period as an opportunity to invest heavily in infrastructure.

Just in case this combination of monetary and fiscal policy largesse leaves some questioning whether that is sufficient to drive equity markets higher, we have one more source of cash to throw into the mix. Corporate share buybacks have experienced a sharp decline in 2020 as companies put a pause on buying their own stock in efforts to protect liquidity. If these purchases return to pre-virus levels, that would imply an additional $500 billion available to buy equities in 2021. In that vein, U.S. banks have received the regulatory green light to return to share buybacks.

And why wouldn’t companies buy back shares? Profitability has essentially recovered. Third-quarter earnings from S&P500 companies (excluding the energy sector) were only down approximately 1% from last year. In Canada, corporate profitability has hit a 2-year high. As we enter 2021 companies are still planning aggressive cost-cutting moves and if this is matched with an uptick in demand as consumers emerge, earnings could move to a new high.

Investor sentiment is highly bullish as can be observed in some of the indicators, but also anecdotally. The share price activity of two high profile new offerings suggests a feeding frenzy on these well-known brands. DoorDash and Airbnb both soared on their first day of trading, with DoorDash peaking at a price 90% above its offering price, while Airbnb priced its issue at $68, but traded almost $100 higher during its first day. Millions of new traders have opened accounts with start-up Robinhood to begin day-trading.

The rise of SPAC’s (Special Purpose Acquisition Companies) is also alarming. In simple terms, SPACs are shell companies funded by a group of investors that also has a stock listing on a public market. The public company then purchases a private company, making it public. This backdoor mechanism to becoming a publicly-traded company avoids much of the due diligence and scrutiny most companies must go through before entering the public markets. SPAC’s have been part of the investing landscape for years, but 2020 saw a huge increase in the volume of deals being done through these entities, from an insignificant portion of the total offerings in 2019 to over $80 billion in 2020.

To top it all off, we have had respected fund managers publicly commenting that valuation levels (which are already near historic highs) could go much higher – even double – based on the low-interest rate environment. Is anyone else who lived through the tech bubble having flashbacks?

Although we would consider these signs of “irrational exuberance,” as Alan Greenspan coined the phrase in 1996, those heady days of the tech bubble taught us an important lesson. These periods of “irrationality” can endure longer than what logic suggests is reasonable.  Prince tells us that “life is just a party and parties weren’t meant to last”, but with plenty of cash still available – $1 trillion more sitting in money market funds today when compared to a year ago, according to data accumulated by JP Morgan, it is hard to see the punch bowl being taken away just yet.

So, with all this liquidity driving equity markets higher, what could possibly go wrong? For those worried about the consequences of this endless supply of free money, there are likely three horsemen (instead of the traditional four) to the apocalypse envisaged. They are interest rates, inflation, and valuations, with the three being intertwined in ways that make it difficult to discuss them in isolation.

Let’s start with interest rates. As governments take on levels of debt unimaginable only a year ago, taxpayers have become concerned about how this debt will eventually be repaid. Governments have generally dismissed the concerns on the basis that interest rates are low. There are two issues with this argument.

The first is that debt can be a drag on economic growth. If debt is used to improve the productive capacity of the economy or drive productivity gains, that is a good thing. The debt accumulated during the pandemic has not been used for this purpose as it has been used primarily to support demand for goods. There is no lasting improvement in the economic capacity of the country. It has also been argued that artificially low-interest rates have kept many “zombie” companies alive, utilizing resources inefficiently and creating an overall drag on the economic potential.

Over the last several decades, debt has increasingly been used to draw the economy out of recession. However, each decade has also generally seen an overall GDP growth decline from the previous decade. Now, this is not purely a result of changes in debt levels, economies are far more complex than that. But it is hard to imagine that an economy that suddenly becomes burdened with high amounts of debt is going to sustain growth levels above those of the prior decade.

Source: World Bank

The second and related concern around debt levels and interest rates is the assumption that interest rates will stay low forever and ergo the debt won’t be a burden.  But we all know that nothing lasts forever. Although the debt may be sustainable now, even a modest increase in interest rates could seriously hamper the government’s ability to react to a future crisis or even to fund normal programs.

Now sing along,
   Everybody’s got a loan
   they never expect to repay
   before I let that happen
   I’ll inflate my debt away…,

Inflation is a blessing and a curse to governments in debt. Higher inflation makes it easier to repay the bloated government debt, but inflation tends to come with higher interest rates that make the interest payments more onerous.

It has been almost 40 years since western economies last had to wrestle the inflation beast to the ground and for over a decade, we have worried more about deflation than inflation. The question is whether broad-based price inflation can resurge.

Economic theory suggests that when central banks print money inflation will be the result. Yet, central banks have been using Quantitative Easing for a decade and inflation has remained elusive. Besides the magnitude having blown up to gigantic proportions, has anything fundamentally changed? William Dudley, the President of the Federal Reserve Bank of New York, has indicated that a temporary surge in inflation in 2021 is plausible as disrupted supply chains face challenges related to a surge of pent-up demand as consumers begin to spend more freely.

When reviewing the inflation data there are always some areas that see increasing prices and other areas that are experiencing declining prices. In reviewing the most recent U.S. data, upticks in prices can be found in areas such as food – primarily meat, and large appliances. What is perhaps more interesting is some of the areas which have experienced price declines, which include, airfare, hotels, and clothing. As the world normalizes and people once again begin wearing pants, it is easy to see where these deflationary offsets to some of the areas experiencing price increases will disappear creating a temporary inflation lift.

Longer-term inflation pressures could be triggered if the much-anticipated infrastructure spending takes place, putting strains on limited resources. For example, a “green” economy requires increased use of copper, but in the short-term, copper supplies are fixed. You can’t add a new copper mine the same way Amazon adds delivery drivers when there is a surge in demand.

The yield curve, which is a way of assessing market expectations for future interest rates is already starting to anticipate higher rates. Although overall interest rates remain lower than they were a year ago, the yield curve has been steepening as longer-term rates have been moving higher on the prospect of a better economy and potentially some inflation.

Source: FactSet

So, why is this a problem? After all, central banks have been desperate to create some inflation and scare away the deflationary bogeyman. The problem is, that much of the foundation for the helicopter drops of money hitting financial markets begin to crumble if interest rates rise too much or unexpectedly.

All of this brings us to the third horseman, valuations. We believe valuations matter when choosing securities. Valuation levels reflect expectations for future growth and when valuations get extended it is because investors have a high degree of optimism as to what the future may hold. The further stretched those expectations become, the easier it is to have a disappointment which requires valuations to be revised to reflect the new, more subdued reality.

Historically the main U.S. stock index has traded at approximately 15 times the annual earnings generated by the companies that make up the index. According to FactSet, as of December 31st that multiple was 22.7 times 2021 expected earnings. In the past when the index has hit this level, average returns over the following several years have been well below average.

This then links back to our discussion on interest rates as the rationalization used to justify higher valuation levels is low-interest rates. In theory, current share prices should reflect the present value of a company’s future earnings. In a world with interest rates sitting near zero and low inflation, the value of those future earnings is higher than in a world with higher inflation.  Higher interest rates or inflation, shatters the argument that justifies these extended valuation levels.

So, are we going to party like it’s 1999 or as Prince says is it “party over, oops out of time”? In the near-term, it seems unlikely that the trend will reverse itself.

That is not to say there won’t be any pauses and we wouldn’t be surprised to see some volatility and a modest pullback in the early part of the year as investors rebalance after an unexpectedly strong performance in 2020. But in the short-term, the money flows to the market seem likely to win the day.

However, this is a vulnerable bull market that could be quickly halted from any number of events. The commonly highlighted concerns include; comments from central banks speculating on the winding down of stimulus (remember the Taper Tantrum, which sent interest rates spiking higher and equity markets lower without the Federal Reserve actually changing anything); a sharper move higher in long term interest rates than currently anticipated; a disappointment in fiscal spending or the pandemic taking a turn that suggests the current vaccines will not be the panacea currently expected.  But bull markets often end on an unexpected event, so we may not know the trigger until after the fact.

Managing through this feels somewhat like dancing in a minefield as we see signs of excess building. The key is to maintain discipline and focus, to avoid getting carried away by the party. For now it seems like we might party on into 2021. So, if you don’t have Prince playing from your Spotify account right now, let’s do it one more time….

Yeah, they say two thousand zero zero party over,
Oops out of time
So tonight I’m gonna party like it’s 1999…

Logan Wealth Management
January 25, 2021

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