Euphoria in the markets: Change in the rules of the game?

Market movements resulted in increases in the internal rate of return of around 10–11 bp over ten years in the American, German and Italian markets, and around nine years in the Spanish market. The European and Latin American stock exchanges rose sharply, such as, for example, the IBEX, which rose by more than eight percent.

These movements are contrary to the trend we have seen in recent months, especially since October, although they form part of a year of high volatility. The key question now is: Is this a fundamental change from what has happened so far this year?

The reasons for the impact can be summarized in that, with a vaccine, investors assume that they can start to turn the page and forget about COVID-19. That is why the movement has focused on European and Latin American stock exchanges, which had been adversely affected by the evolution of the pandemic, and US Treasury bonds, the main valuation factor for which was the expectation of a Fed at a low and providing liquidity for a long time, partly due to the impact of the pandemic. Moreover, Biden’s victory, though not definitive, leads investors to think that global trade relations could improve, resulting in increased activity in Europe.

Here, the key question is when will we be done with the COVID-19 issue? We do not know yet. The news of the vaccine has awakened investors to a reality, in this case, a more positive reality, that, at some point in the future, this will happen. Regardless of whether the subsequent economic structure will differ from the pre-existing one. However, the reality is that, at some point in the future, probably in 2021 or 2022, either there will be a vaccine or we will have learned to live with COVID-19, just as we live with many other illnesses.

It also very clearly shows a problem in assessing the investor horizon: The harm of the last two months, focused on Europe, is based on the damage expected from the authorities’ reaction to the increased rate of infection. But that completely overlooks the long-term. It is also what we already knew. The second wave taking place in Europe was clearly announced in April–May by health experts. And, during the summer, investors optimistically forgot about it and so, in October, it took them by surprise.

Certain questions now arise. In their response, it is important to differentiate between the initial effect of alleviating concern regarding the pandemic (which favors mainly Europe and Latin America) from the long-term effects on a post-Covid economy (in which China and the US seem better placed, if the policies in the latter are continuity policies).

In any case, some of the most immediate questions are as follows:

1.- What is going to happen to the huge amount of new money that has been created to fight the pandemic?

We do not know. But, on the one hand, it will bolster the asset price. On the other, it also poses a high risk of consumer inflation in economies that recover best and/or whose companies have the highest pricing capacity. In addition, there will be detrimental effects in terms of social inequality. However, for markets, the overview, over two to three years, is likely to be positive.

2.- Will rates rise or will liquidity decrease?

This question is implicit in the above. And that still depends on each economy. Most central banks have clarified their intention not to raise rates or restrict liquidity quickly, and technical tools have been put together to do so. This possibility is therefore not envisaged within a reasonable forecast period. However, if inflation expectations, for example, continue to rise in the US, the market would start to price it. Moreover, if we leave the pandemic behind us, it is highly likely that the liquidity provision will be stopped smoothly, similar to what the Fed did in the summer. This would not remove the huge support that already exists, but it would stop it from expanding.

3.- Which economies will grow the most?

It is impossible to know in advance, but the US and China seem best placed for a post-Covid economy, provided that, as a result of the American elections, the new government does not apply a pure democratic agenda. Namely, continuity policies should be maintained, which would be linked to the sharp increase in liquidity that is reaching the American real economy.

4.- What is going to happen to stocks?

Stocks are driven largely by mass liquidity. Similarly, sectors or companies that appear to be winners in a post-Covid economy have been invested in. In this sense, there will likely be a second phase of “discrimination” during which these initial investments will or will not be shown to be successful. In any case, the effect on stocks as a whole is initially positive in the short-term.

5.- What about bonds?

The effect on government bonds is the opposite. It may also be much more intense, especially in the US. A universe of government bonds with negative internal rates of return causes these instruments to forfeit their main role: to protect portfolios. Moreover, although they have so far fulfilled this role, it cannot be guaranteed that they will continue to do so in the future. However, this does not mean that we are going to see a massacre in terms of debt. On the contrary, central banks have a greater incentive than ever to act as a support in this case, as the ECB is already doing. However, the trend in curves is upward, or, at least, returning to pre-pandemic levels, remaining very moderate.

6.- What will happen to exchange rates?

Strangely enough, these have barely changed. The dollar has weakened following the elections, but we cannot know what it will do in the future. So far this year, the main factor that has affected currencies, namely, the EUR/USD, has been the increased relative liquidity of one or the other provided by the respective central banks. In addition, there has been an upward step in the equilibrium value of the euro with the May–June agreement. Monetary policy will most likely remain king, but expected profitability, i.e., relative growth and currency demand via trade/reserves, may be more important.

In conclusion, is this a fundamental change?

Yes, but not because of the vaccine itself, but because it reminds investors that there will be a post-Covid world, something they had forgotten in recent months. And, with a long-term focus, it is more important to think about that than what will happen in the next three months.