But sentiment changed abruptly when former President Donald Trump banned travel from most of Europe and the World Health Organization officially declared Covid-19 a pandemic on March 11th.
Most recently: many of the features of 2020 are still evident, and not just in closures, social distancing, and working from home. The exuberance that has defined equity markets over the past twelve months has continued to push stocks to all-time highs this year.
The coronavirus is still with us, but now investors are embarking on a quick and strong recovery as vaccine launches pick up the pace and the United States is gearing up for another huge stimulus package.
Goldman Sachs forecasts 7% growth in US GDP in 2021, a level not seen since 1984.
High risk: As at this time last year, equity investors may be underestimating the size of possible setbacks. Ironically, a booming economy may not be good for equities, as it could increase corporate financing costs and steal the core value of equities: higher returns.
While a good recovery is good for corporate profits, higher rates make debt more expensive, which could become a problem for companies that have borrowed heavily during the crisis. Stocks also seem relatively less attractive when bond yields increase.
Keep calm: The Federal Reserve has made it clear that it is willing to tolerate higher inflation if it means companies are recovering and unemployment is falling.
Given that the U.S. labor market still has fewer than ten million jobs since the pandemic hit, it may be some time before rates recover.
“The backdrop will continue to be pro-equity in 2021,” Roger Jones, head of equities at London and Capital, told me. “Long-term structural winds in inflation (demographics, technological advancement and high debt levels) are stronger than ever. In addition, stocks can cope with inflation as long as it does not stay above the 3% level. “Jones said.
The European Central Bank could have a new problem
A sustained rise in consumer prices may seem a long way off in Europe, where economic activity remains severely constrained by blockages, stimulus is limited and this year’s GDP growth prospects have weakened.
Despite all this, inflation has intensified in the region and, if bond yields continue to rise, policymakers could end up being forced to take action.
What’s up: The European Central Bank meets on Thursday and investors will want to know how inflation thinks. They will also want ECB President Christine Lagarde to say the central bank has no plans to tighten funding conditions.
“The ECB will primarily try to minimize the recent increase in bond yields, calling it small-scale, driven by technical factors and focused on real yields,” ING research chief Carsten Brzeski wrote on Friday.
Brzeski expects the ECB to insist that asset purchases could increase if necessary and move to early stimulus in the coming weeks to maintain favorable financing conditions.
See here: in an interview last month with The Economist Lagarde, he said the ECB has used approximately € 800 billion ($ 955 billion) of its 1.8 trillion pandemic emergency purchase program. euros (2.1 trillion dollars).
“We still have a lot of it. If we need everything, we will use everything,” he added.
However, as recent volatility in bond markets indicates, many things can change in a few weeks. Once economies reopen, a sudden rush of goods and services could lead companies to raise prices. Excess savings in Europe will also affect the recovery if families spend some of that extra money.
“Once restrictions are lifted and fear of the virus is reduced, it is reasonable to expect prices to rise,” ING economists, including Brzeski, wrote in a note last week. “Overall inflation in the eurozone could easily accelerate above the magic level of 2% this year.”
Overview: At least for now, the European economy seems a long way from overheating. GDP contracted again in the last three months of last year amid further blockages, and with many of these measures still in place, growth is unlikely to go much better in the first quarter.
Slow deployment of the vaccine and relatively modest stimulus will also weigh on Europe’s recovery. In the absence of wage increases, the ECB is unlikely to react to short-term changes in inflation, Brzeski said.
Until next time
Friday: US PPI and consumer sentiment, EU industrial production