Last year was a dizzying time for investors. The global coronavirus pandemic triggered a historic sell-off in the stock markets only for them to mount a stunning recovery in equities before the end of 2020.

Although forecasts proved correct in predicting that the pandemic would cause widespread economic decline, small business closures, high unemployment and massive strain for healthcare systems, stock markets beat expectations by even exceeding the record levels registered before the crisis.

The sharp rebound was supported by the fast response from governments and central banks.

The Federal Reserve dropped interest rates from already low levels to zero, to make borrowing easier.

As global trade collapsed and domestic economies ground to a halt, corporations used cheap debt to support their operations.

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Governments around the world overcame ideological objections to mount direct interventions in the economy and the job markets with stimulus measures supporting furloughs and the unemployed.

Direct payments to households, like in the United States, helped halt the decline in consumer spending.

The prospective end of the pandemic, with the advent of vaccines, then pushed up the market valuation of companies in a rally at the end of the year.

“Last year provided the perfect confirmation of valuable advice that’s long been given to investors: remain invested and do not panic when the market reacts to uncertainty,” said Monique Frederick, head of asset management at Butterfield Bank.

The year 2020 also demonstrated a disconnect between the real economy and the stock market.

“Markets are forward looking, and this detachment occurred as the focus turned to the possibility of a vaccine, alongside continued and increased monetary and fiscal stimulus; all necessary ingredients for a recovery,” she added.

This year, Frederick said, global economic forecasts are much more optimistic. As vaccines are rolled out and pandemic risks begin to recede, the economy should bounce back strongly due to pent-up demand for goods and services.

Democratic control in the White House and both branches of Congress, meanwhile, paves the way for increased government spending in the US, which will boost GDP.

In addition, it is widely expected that the Fed will maintain base interest rates at zero throughout 2021.

Frederick said these factors are all supportive of an economic recovery this year.

“For your investment portfolio, this translates into continuation of a low interest rate environment, but a modest increase in bond yields and continued support for equity markets, with US equities still leading the way.”

Scott Elphinstone, chairman of the investment committee at Five Continents, also predicts that equities will remain in a bull market in 2021, supported by short-term interest rates which should remain near zero for the next two or three years.

“The market is looking forward to the end of Covid-19 brought about by mass vaccination and is largely ignoring the weak economic conditions of today,” he said.

The combination of equities prices near high historical valuations with record-low interest rates should result in a heightened level of volatility, Elphinstone added.

“This does not mean that we need to be scared of investing, but it does mean that you need to manage risk accordingly.”

This can be accomplished by positions sizing and diversification, he said, and recommended investors use a professional investment advisor, who can help establish personalised risk-return objectives and assist with overall asset allocation.

In the current market environment observers see pent-up demand in almost all aspects of life that are currently restricted amid lockdown measures and social distancing – from family vacations to mass events.

But question marks remain. The new COVID mutations pose a near-term risk to the recovery as they spread around the world. The supply and distribution issues affecting the rollout of the vaccines and some uncertainty about their efficacy will determine market movements this year.

Businesses meanwhile are concerned about higher taxes and stricter regulations which contrast with the prospect of reopening economies.

For the time being, however, the expansion of central banks’ balance sheets is expected to continue, albeit at a slower pace, and should anchor interest rates at very low levels for the immediate future.

At the same time, more stimulus measures are planned in the US and Europe, the size of which will shape market trends.

Alessandro Sax, portfolio manager at NCB, believes 2021 will be very positive for stocks as the recovery continues to take shape and economies reopen against the backdrop of unprecedented fiscal and monetary stimulus.

He argues that in contrast to previous years, 2021 will not be led by technology and especially the FANG (Facebook, Amazon, Netflix, Google/Alphabet) stocks.

Sax advises investors should, if they have not already done so, continue to shift their portfolio from ‘stay-at-home/COVID stocks’ to more economically sensitive ‘reopening’ stocks that can take advantage of the economic recovery.

Stock market valuations

The astonishing rebound since March, led initially by tech stocks, does raise some questions about overvaluation and the potential for bubbles.

There are definite signs of excess in the financial markets as loose monetary policy and record-low bond yields prompt market participants to take on more risk.

Currently, most stock indices are trading well above their long-term price-earnings averages.

However, a recent analysis by RBC Wealth Management highlighted that when the five largest technology stocks (Apple, Amazon, Microsoft, Google, and Facebook) are excluded, the forward P/E ratio of the S&P 500 drops from 22.5 times to 17.5 times.

Compared to the 10-year average of 16.4 times for the S&P 500 as a whole, this suggests that “while valuations are expensive, they are not significantly overvalued”, the RBC’s Global Portfolio Advisory Committee wrote in its weekly briefing.

Stock valuations are nevertheless one aspect to consider.

“There are areas of the market that have become very speculative in nature with very stretched fundamentals,” said Sax. “I’d steer clear of trying to chase stocks that already have had astronomical run-ups.”

Red flags

The financial markets are seeing an accumulation of red flags. Cheap credit in combination with the fear of missing out, along with headline-grabbing gains from Bitcoin and GameStop to Tesla, may well be the harbinger of a market correction.

However, there are always warning signs when a stock market is on an extended period of increases, said Elphinstone.

He sees many examples of speculative behaviour, also noting that valuation measures are high by historical standards, as well as the start of government antitrust actions in the technology sector.

But some red flags alone will not indicate the advent of a fully-fledged bear market.

“While these are instructional, bear markets never start just because of warning flags starting to pop up,” he said. “Markets can stay at elevated levels – with temporary corrections from time to time – for years. You can never see coming what actually triggers an extended bear market.”

Certain threats like “stronger than expected inflation is a possibility we debate,” Elphinstone said, “but that would be at least two years away.”

Frederick agrees that equity valuations seem stretched compared to historical levels and are susceptible to a market correction. Like Elphinstone, she argues that in addition to obvious warnings signs there are always unforeseen risks.

“For that reason,” Frederick said. “It remains especially important to maintain a diversified portfolio and stick to a holistic, long-term investment plan.”

What asset classes are in focus?

Generally, exposure to multiple asset classes is better than investing in just one asset class, which increases the risk.

NCB’s Sax said in his view corporate bonds have the highest level of risk in the current market. “They offer little to no yield and are priced to perfection. Not to mention their negative performance in a potential future rising interest rate environment.”

Although bonds do not seem attractive in this historically low interest rate environment, Frederick said, it is worth noting that, despite the March stock market crash, both equities and fixed income provided opportunities to outperform last year.

She said that, rather than coming from drastic changes in asset class allocations, opportunities to outperform this year are within the asset classes themselves.

“On the back of the vaccine news in early November, we have already witnessed large sector rotations into energy, and financial stocks, away from stocks that benefited from the work from home movement.

“We’re also seeing a historic shift from defensive stocks into cyclicals. In anticipation of the increased fiscal spending packages, alongside continued monetary support and a weaker US dollar, the inclusion of inflation-protected securities, as well as commodities, are themes we’re currently considering.”

A successful vaccine roll-out would also prove beneficial for the beaten-up tourism-related sectors.

Frederick said, “From an overall tactical asset class allocation we have entered the new year the same way we approached the end of 2020: underweight fixed income, neutral equities, and overweight non-traditional asset classes and cash.”

Five Continents is similarly looking at ways to generate additional yield from its portfolios, said Elphinstone.

“We are investing in private credit, hedge funds as well as rebalancing portfolios that can take more risk to hold more equities.”

However, the alternatives are different for each investor and depend on the individual risk-return profile.

Frederick said, “2020 was an exceptionally challenging year for all of us. Some of us lost our livelihood; some of us lost friends or family members; some of us had to become part-time school teachers; and many of us had to work from home. All in all, we had to adapt and we had to do it quickly.

“In the same manner, I encourage investors not to be swayed by daily market noise but to focus steadfastly on their long-term financial goals and seek professional assistance if needed to navigate ever-changing market conditions,” she added.