Contrarian scenarios that could upset the market consensus

This is the time of year when financial analysts figuratively gut the global economy and examine the entrails to divine what the next year might hold. What is always a difficult exercise looks particularly hopeless right now.

It is tempting to mock the tsunami of year-ahead outlook that gushes out of investment banks’ research departments this time every year. When someone turns out to have nailed a prediction for where bond yields or the stock market are heading it is often more down to luck than forecasting ability.

It is safe to say no one saw how 2020 would shape up, for example. But truthfully, even if a fortunate analyst had enjoyed a spell of divine revelation and been told by the sellside gods that the world would suffer from its worst pandemic in a century and swaths of the global economy would judder to a halt, it is likely they would still have struggled to predict where markets have ended up this year.

Nonetheless, although most analysts will willingly admit to the fruitlessness and frustration of having to pump out year-ahead forecasts, the exercise itself is valuable. It helps to construct a mental framework, and the value is in the thoughtfulness of the analysis, not the price level targets or yield forecasts. Moreover, it gives analysts an excuse to spend quality time with their investment manager clients, even if it will have to be virtually over the Skype, Zoom, Teams or BlueJeans apps this year. 

Unfortunately, there is a relatively bland consensus about what the current year holds, with nary a single analyst diverging meaningfully from the central scenario. That is a testing few months as the second coronavirus wave takes its economic toll, but then a strong economic recovery in 2021 powered by vaccines and ultra-easy monetary policy. This is expected to lead to higher stock markets, somewhat higher long-term bond yields, a weaker dollar and another good year for corporate credit. Plus ça change. 

The only disagreements surround just how strong the equity rally will be, whether value or growth stocks will dominate, how high the 10-year US Treasury yield might venture, whether the dollar will slump or merely slink lower, and whether junk bonds or emerging market debt will do best. 

So for the record, here are some deliberately (if only slightly) contrarian suggestions for where financial markets could surprise the consensus in the coming year.

Equities are likely to climb higher, but pricey growth stocks could continue to outpace cheaper value stocks. This is partly because the Democrats will probably eschew a full-on assault on fast-growing Big Tech companies. Growth stocks will also benefit if treasury yields do not climb much more. These are valued at a premium because of future earnings rises. If yields increase, these earnings are discounted by higher rates.

For sure, the shape of the Treasury curve will fluctuate as investors wrestle with the ebb and flow of economic data. But under a contrarian scenario, it will not end the year meaningfully steeper, and could easily flatten. Inflation would remain quiescent and low rates globally would help keep long-term Treasury yields capped. 

In this scenario, inflation-protected US government debt — a perennial favoured pick by analysts around this time of the year — could once again prove disappointing.

The burst of investor love for emerging markets is harder to argue with. Although the MSCI EM index is up over 10 per cent since summer — almost twice the S&P 500’s gain — it still trades at nearly half the price-to-earnings ratio. This discount seems excessive by historical standards. But emerging markets do have a nasty way of disappointing when optimism is this high.

One of the most contrarian investment themes of 2021 could be to short volatility. In other words, sell derivatives contracts that provide other investors with insurance against stock market turbulence. Although risky, the severity of the market mayhem of 2020 means that many volatility-sellers have been carted out and investors are still paying a healthy premium for protection.

Finally, sentiment around the dollar is already so bleak that it might be tempting to think the US currency will actually strengthen slightly in 2021. 

But perhaps the biggest immediate uncertainty for financial markets is the upcoming Senate races in Georgia. If the Democrats triumph and win control of both houses of Congress and the White House, they could pursue a far more ambitious policy agenda.

That is likely to mean a greater fiscal stimulus coupled with sweeping tax increases and a re-regulation drive. Given how much this is at odds with current expectations, this would almost certainly lead to market upheaval.

robin.wigglesworth@ft.com