Confidence in the recovery shifts attention towards risks of excesses – Dorval's Macro Corner (February 2021)

"Adapting economic knowledge to market realities and breaking free from the tyranny of indices"
François-Xavier Chauchat
Member of the Investment Committee, economist and strategist.

Reassured by the resilience of the economy and by vaccination prospects, investors have become more worried about excesses. Have stock markets risen too fast? Will successive US stimulus packages cause inflation and interest rates to soar? Are some bubbles threatening to burst? Some of these concerns seem legitimate, others less so.

The economic recovery and the existence of bottlenecks (raw materials, shipping) will certainly push up some prices in 2021, but betting on a lasting, excess inflation remains highly speculative. At this stage, we are only witnessing a normalization of US inflation expectations, which can only be encouraged by the Federal Reserve. The Fed does not intend to change its policy so early in the recovery phase, aware that inflation could again miss once the economic acceleration has passed. The plan remains to regain lost economic ground, especially on the employment front. The success of this plan is credible in the United States but remains uncertain in Europe and in many emerging countries.

Investors are also worried about the consequences of a (probably partial) normalization of US long rates on world stock markets. However, the relationships between interest rates and equity valuations are complex and ambiguous. For example, if valuations had followed the decline in interest rates over the past 15 years, equities would be much more expensive. Most measures of the equity risks premium remain at comfortable levels, which was not the case in 1987 or 2000.

It is the perception of risk that drives financial market movements. Initially fearing a crisis ala 2008, investors have been reassured by the behaviour of equity markets in the face of the Covid-19 crisis. This is the reason why flows into equity markets have been so strong recently. This impression of comfort sometimes leads to excesses, as evidenced by the popularity of stock trading applications, with sometimes irrational crowd phenomena (i.e. GameStop). Enthusiasm for many high-tech themes also leads to suspicions of bubbles. But investors' strong appetite for risk is a classic post-crisis configuration that sometimes last several months.

The fear of irrational exuberance is put into perspective by the sharp recovery in listed companies' profits. On Wall Street, profits end the year 2020 up +2% compared to Q4 2019. Even if Corporate America still dominates the global profits scene, some sectors of the European stock market have fared well, especially small caps. These profit performances are remarkable while the economy remains far from its trend growth path.

In our portfolios we seek to capture the recovery in corporate profits through the themes of green deals, "post-Covid" sectors (tourism, banks, etc.) and industrial recovery in North Asia. We manage risk by seeking strong diversification and modulating market exposure around moderate levels. Our bond positions remain virtually non-existent.


Download Dorval’s Macro Corner of February 2021 in PDF version here

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