What’s next for markets?

What if interest rates stay at record lows pushing asset valuations higher and higher?

For the global economy and financial markets, the broader continuation of the coronavirus pandemic, as well as the global policy responses, remain the key drivers for the macro outlook.

In the second-half of this year, markets have shown resilience to the Covid crisis even as the second wave worsens through Europe and North America. But unprecedented levels of fiscal and monetary stimulus have underpinned shares, pushing valuations high.

Effective Covid-19 vaccines and unprecedented fiscal stimulus is expected to see a snap-back in the economy with pent-up spending unleashed by growing consumer and business confidence. This has been likened to a repeat of the “Roaring Twenties” of a century ago, which followed the Spanish flu pandemic of 1918.

Australia’s economic recovery is widely seen to be well underway. As the spread of the virus was controlled and restrictions eased, the economy grew strongly in the September quarter - 3.3 per cent - with momentum expected to continue into the December quarter.

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Official Treasury forecasts updated this month have Australia’s GDP in calendar 2020 falling by 2.5 per cent, before growing by 4.5 per cent in 2021.

Activity will be supported by the fiscal economic support measures and, over time, a gradual easing of social distancing restrictions and continued improvements in confidence.

For its part, brokerage Merrill Lynch sees “solid growth” of 3.6 per cent for Australia in 2021 driven by economic reopening and policy support, but cautions the growth will be uneven.

A key moment for the economy and markets will be the planned phasing out from March of emergency support measures that were introduced to support households and businesses through the worst of the pandemic.

Another drag on Australia’s growth could come from trade friction, between Australia and China, which could hamper Australia’s export recovery next year.

While the Australian government appears to have ordered enough doses to vaccinate its population several times over, the distribution is targeted for the March quarter, behind the US and European rollouts.

At the same time, local authorities are not yet convinced that Covid vaccines will stop the spread of the virus. The rate of the spread of the virus remains low in Australia, and the uptake rates of these new vaccines are yet to be seen.

But if the vaccines are indeed a panacea, share prices relative to their expected earnings in the next 12 months or through the business cycle could prove to be cheaper than they now appear.

The alternative

The other alternative is that interest rates stay at record lows pushing asset valuations higher and higher.

Westpac chief economist Bill Evans said one significant issue stands out from a policy perspective.

That is how the RBA will address its quantitative easing program after the committed $100bn of purchases of government bonds is completed by early May 2021.

Mr Evans expects that the RBA will at that point decide to extend the program for a further six months, with another $100bn in committed purchases. In 2022 he expects the RBA will reduce the quantitative easing program to $50bn per six months and gradually raise the rate for the three-year bond target through the year, reaching 0.3 per cent by year’s end.

Meanwhile, he expects the Australian dollar will rise to US80c over the course of 2021.

There is the underlying risk of an inflationary spike from all the cheap money washing around the financial system. There’s little sign of such a spike yet, but it is one that policy makers are closely watching.

The first sign of a shift in interest rates is likely to trigger a sharp-pull back in shares.

For his part, AMP Capital’s Shane Oliver said shares are at risk of a “short term correction” after having run up so hard recently, and 2021 is likely to see a few rough patches along the way - much like the recovery from the global financial crisis.

“But looking through the inevitable short-term noise, the combination of improving global growth helped by stimulus and vaccines and low interest rates augurs well for growth assets generally in 2021,” Dr Oliver says.

He says there is likely to be a continuing shift in performance away from investments that benefitted from the pandemic and lockdowns - like US shares, technology and health care stocks and bonds - to investments that will benefit from recovery - like resources, industrials, tourism stocks and financials.

He argues that Australian shares are also likely to be relative outperformers helped by better virus control. Sectors like resources, industrials and financials are benefitting from the rebound in growth, while investors searching for yield are also boosting shares, Dr Oliver says.