Markets Have Mostly Stuck To The Script This Year. So What Happens Next?

Markets Have Mostly Stuck To The Script This Year. So What Happens Next?
Andrew Rummer

almost 3 years ago6 mins

Mentioned in story

As we come to the end of May – and the start of what’s historically been the quieter summer period – it’s time to take stock of the markets so far this year, and look at where we go from here.

How did we get here?

It’s worth taking a moment to remember just how bad the economy was in early 2020, when COVID-19 morphed from isolated Chinese health crisis to fully fledged pandemic. Citigroup’s US economic surprise index is positive when economic numbers are coming in better than forecast, and negative when they’re worse. And according to that gauge, the world’s biggest economy in the spring of 2020 was in a worse spot than in even the darkest days of the 2008 financial crisis. 

Chart of the Citigroup US economic surprise index
Citigroup US economic surprise index (source: Bloomberg)

But it’s also worth recalling how quickly and strongly the US economy rebounded from that 2020 shock. Citigroup’s surprise index took just 10 weeks to hit a new peak, compared to nearly six months in 2009. And the size of that peak is off the charts compared with any previous recovery. 

The surprise index slipped back below zero briefly this month for the first time in nearly a year, suggesting that we’re now into a new phase where economists’ expectations have caught up with the current reality. And the current reality is showing promising signs: global data shows the number of new coronavirus cases dropping rapidly in the past few weeks. 

Chart of global change in recorded coronavirus cases
Global change in recorded coronavirus cases (Source: Bloomberg)

A similar picture is emerging for US-listed companies, which have posted a 52% increase in first-quarter profit compared to the same period last year. European firms, meanwhile, have reported a massive 93% gain. But stocks have barely budged since the start of the most recent earnings season, probably because investors were well prepared for such lofty results.

Put simply, the worst human and economic effects of the pandemic appear to be behind us – but so is the initial burst of recovery. 

How have markets performed this year?

Stocks are higher in most places, and there’s been a broad rotation from so-called growth sectors like tech to value sectors like banks. If anything, though, stocks have climbed faster than expected – particularly in the US.

Bond markets globally, meanwhile, are down a little as investors prepare for a pick-up in inflation. Declining bond prices have pushed up yields, as well as reduced one oddity of contemporary markets: the global stock of negative-yielding debt has dropped to about $12 trillion from more than $18 trillion in December.

Real estate and commodities have also performed well as investors hunt for havens from inflation. US home prices, for example, had their biggest jump since 2005 in March, according to data released last week. 

This is all broadly in line with consensus expectations at the start of the year. 

So everything’s happening as expected?

Yes and no. One common prediction at the start of 2021 – that emerging markets were primed to shine – hasn’t quite worked out. The MSCI Emerging Markets Index is only up 5% in 2021, compared to a 10% gain in developed markets stocks. 

There were also plenty of more bearish commentators raising their voices in the early weeks of 2021, pointing out that Tesla’s heady valuation and the sheer amount of money flowing into special-purpose acquisition companies (SPACs) were signs of speculative excess that heralded an imminent stock-market crash. 

Jeremy Grantham of Boston-based fund manager GMO, for one, was ringing the alarm, telling Finimize in January that “there's never been this level of craziness without a 50% bust.” 

Those fears have so far proved unfounded, and stocks remarkably calm. In fact, stocks have gone more than six months without a 5% pullback, the longest stretch since 2017. 

Instead, the frothiest parts of the market – SPACs, initial public offerings (IPOs), Tesla shares – have sold off, but without contaminating the broader market. Those investors seeking high-volatility thrills have instead since moved into crypto trading – which might be why, according to data from Quiver Quantitative, the number of posts on Reddit’s Cryptocurrency forum recently overtook the number on WallStreetBets – a center for stock market trading tips.

What happens now?

Sorry to say it, but no one really knows. It’s so contingent on central banks’ next moves, after all. 

At the heart of everything markets-related at the moment is central banks’ – particularly the US Federal Reserve’s (the Fed) – support for risk-taking behavior. Hence why there’s so much focus on inflation data at the moment. 

The Fed’s betting it can keep the pedal to the monetary metal, with no increases in interest rates until 2024. But if inflation gets out of hand it’ll have to rapidly hit the brakes, and that would almost certainly hit the valuations of every risky asset – from stocks to crypto – hard. 

The consensus of markets at the moment is that the Fed will be forced to hike a little sooner, probably in 2023. But it’s not hard to find people who think even that timeframe is optimistic: Morgan Stanley’s CEO said last week that he reckons the central bank will be forced to step in and begin raising rates as soon as early 2022. 

The question now is: does the global economy return to the trend we’ve seen since 2008, with tepid growth, inflation, and increasing central bank support? And if so, will that bring the unwelcome side effect of higher asset prices and more pronounced inequality?

Alternatively, do we break out into a more inflationary regime of stronger economic growth accompanied by faster-rising prices – with central banks finally able to raise interest rates without immediately spooking investors?

After hearing inflation hawks cry wolf again and again since 2008 that central bank stimulus would lead to imminent hyperinflation, I struggle to believe that the 21st century’s disinflationary trends won’t soon reappear. But, equally, the size of the current combined kick from governments and central banks – particularly in the US – means there’s a greater chance than any time since the global financial crisis of inflation becoming entrenched. Either way, be prepared to hear the i-word more and more in coming months as investors jump on every new data point. 

Key Takeaways

  • We’ve been through a roller coaster ride for economies and markets around the world that’s slowly become more predictable over the course of 2021. So far, the consensus opinions of steady but tepid growth for stock markets, with some rotation from growth sectors to value sectors have been turned out to be broadly correct.
  • The most bearish voices from the start of the year have proven overly pessimistic, with only crypto markets suffering a serious sell-off in 2021 (and even then remaining well in the green for the year).
  • But as US economic surprises threaten to turn negative once again, it feels like we’re at the end of the recovery phase and embarking on a new and uncertain period for markets. Inflation data is likely to be key for the rest of 2021 as it’ll dictate how hard central banks like the Fed can keep pumping their support for the economy.
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