Since the U.S. election and the announcement of Covid-19 vaccines, markets have been bullish. However, investors willing to take risks should also keep in mind that there are alternatives to every scenario. An overview of bull and bear scenarios from Morningstar.
To put it bluntly, the greatest danger in the capital markets at present is that investors are tripping themselves up with so much optimism, says Ali Masarwah of Morningstar, commenting on the current mood. On the cusp of the new year, capital market experts painted a rosy picture of the future in an almost frightening unison.
What can happen when the economic optimists gain the upper hand is shown by the list of winners in November: The MSCI sector index for energy stocks rose by a good 25% (euro-based). The country indices of Spain, Italy and Austria, which are all bank- and/or commodity-heavy, also rose by around a quarter. Emerging market indices, such as those for stocks from Turkey, Brazil and Russia, were also among the big winners.
There are prominent advocates in the bull camp, Masarwah says. Goldman Sachs, for example, had forecast these days that the U.S. leading index S&P500 could rise by a good 20% from today's level again by the end of 2021. Even though most other major U.S. banks were more conservative in their calculations, the majority of them would also see a decent single-digit increase in U.S. equities for 2021. The optimism does not only apply to U.S. stocks, but to dividend stocks worldwide.
The most promising winners
The most promising winners under this positive economic scenario will be the November stock gainers listed above, which still have a lot of ground to make up, given that these are the industries, countries and regions that suffered particularly badly in the wake of the Covid 19 pandemic as the global economy collapsed. Even at the end of November, energy shares were still trading a good third below their level at the beginning of the year. Turkey and Brazil stocks are also down as much as 30%.
Eurozone stocks have held up somewhat better, down just under 3%, and the DAX stands at a mini-gain of 0.3%, the same as in early 2020. By comparison, the U.S. benchmark S&P500 index is up nearly 6.5% this year from a euro investor's perspective; the Nasdaq-100 index even shot up by nearly a third. This has consequences for valuations: As measured by Morningstar's fair value estimates, U.S. stocks were trading well above their fair value in early December; European stocks, by contrast, were mostly undervalued.
So what does this mean for the big picture? Since the central banks are rightly pursuing a very loose monetary policy to support the economy, flanked by an expansive fiscal policy on both sides of the Atlantic, one is rightly reminded of the situation in recent years, when two scenarios dominated the capital market outlooks of banks and fund houses at the end of the year: "Goldilocks" and "TINA".
The Siren Songs of "Goldilocks" and "TINA
As Masarwah explains, the Goldilocks scenario is derived from an English fairy tale, in which a girl gets lost in a forest, arrives at the abandoned hut of the three bears, eats a just-right warm porridge and then lies down on the just-right soft bed. One speaks of a Goldilocks economy when economic growth is robust, inflation is low and interest rates remain low. This, he said, is the stuff of which an equity bull market is made.
Support continues to come from the bond markets. Although safe-haven bond prices corrected to coincide with the jump in equity markets in November, beyond a small jump in yields, bond markets proved remarkably stable. And if bond prices persist at high levels, bond yield opportunities are limited. That, in turn, leads without circumstance to the TINA scenario, Masarwah said. This acronym stands for "There Is No Alternative.". Shares are therefore the only alternative.
The combination of low interest rates, very wide fiscal policy spending pants and stable corporate earnings (which tended to surprise on the upside in the third quarter) could ignite a price turbo in equities and give investors in risky securities a good year in 2021, he continues. That investors adhere to this scenario is shown by the monthly funds flow data collected by Morningstar. In September, especially in October, investors again invested in risk funds to a decent extent. Equity funds were in demand in both months, and for bond funds, investors took more risk in October in search of adequate returns. "So you're going "yield hunting" with TINA and Goldilocks, Masarwah states.
And if everything turns out differently?
The almost unthinkable alternative scenario, i.e., the danger that everything will turn out differently, plays second fiddle for the vast majority of investors, he says. If investors are unanimously optimistic, it could well be, skeptics say, that most are already invested. So the powder is already shot. One indicator of this is the low cash ratios for funds. As of the end of October, the cash ratios of global equity funds were already at their lowest level since the financial crisis of 2007-09. So the fuel for further price increases could be missing.
"Perhaps bond investors are right in the end with their unchanged pessimistic view on the state of the global economy, which could be derived from the unchanged high prices", Masarwah points out. According to this scenario, accidents could still occur along the path of economic recovery that would require a reassessment of capital market risks; or an escalation of the pandemic could cause another slump in the economy; or sufficiently large fiscal policy stimulus could fail to materialize, with devastating consequences for corporate profits.
"Perhaps investors should act with similar prudence amid the euphoria", says Masarwah. Many had already done so with bold buying under different auspices at the height of the Corona crisis in the first quarter. They would then heed the advice of Warren Buffett: Be greedy when others are scared and be scared when others are greedy. "And even if you follow the arguments of the bulls, you should not put all your eggs in one basket. May the siren songs of Goldilocks and TINA still sound so seductive", Masarwah concludes Morningstar's look at year-end bull and bear scenarios.