Calls for spending splurge could seriously disrupt equity valuations
Michael Mackenzie
The Federal Reserve building in Washington. Central banks in the US and the eurozone are expanding their balance sheets © Reuters
As investors chase equities and drive share prices higher, another important market development should not escape notice: Government bond yields have bounced from their lows of August and their role as a driver of broader market sentiment remains paramount.
Much of the current enthusiasm for equities reflects expectations of a rebound in economic activity, nurtured in part by the stimulus that was provided by the sharp decline in sovereign bond yields during the summer — the flipside of rising debt prices.
Now as central banks in the US and Eurozone expand their balance sheets, thereby adding another chapter to quantitative easing, equities and credit remain buoyant, and strategists figure there is room for further gains in 2020 for risk assets.
These outlooks usually come with the reassurance that long-dated yields for Japan, Germany and the US will not experience a large and sustained rise.
For equity markets, slumbering so-called “risk free” 10-year bond yields over the past decade help explain why there is a substantially lower risk premium attached to owning shares and credit.
Once US Treasury yields fall towards record lows, equities look far more compelling on a comparative basis.
Whenever market turmoil erupts, bond yields fall farther and their appreciation in price terms helps investment portfolios offset declines in their share market holdings.
This is where the virtuous, or vicious circle is created, depending on your view: the chance of a slide in equities fades when ever yields decline.
The bullish mood dims only if bond yields rise significantly from here, as it would eventually make fixed income more attractive to own in comparison to equities, thereby hitting the valuation argument that currently favours shares.
Many investors look at the coming decade as representing more of the same in terms of sluggish economic growth and modest inflation pressures. But thanks to low sovereign yields, this preserves the buoyancy of equities.
Such thinking rests heavily on the failure of aggressive monetary policy actions of central banks since the financial crisis to counter the robust trends of ageing demographics and the price crushing prowess of technological innovation to generate stronger growth and higher inflation.
A notable consequence of low yields has been a borrowing binge by governments and companies.
Ever rising debt levels also limit a sharp rise in yields as they start throttling an economy and financial markets that are overly reliant upon high levels of borrowing.
Investors may feel comfortable about the long-term trends for inflation and growth, but populist politicians have been quick to spot the chance to gorge on cheap borrowing. G
iven the state of the global financial system, which has delivered few rewards for average wage earners while generating strong asset-market gains, this is perhaps inevitable.
That is why some reckon the status quo faces a challenge, with big implications for the current financial market complacency.
Analysts at Bank of America Merrill Lynch raise the risk of “diminishing returns from increasingly activist central banks and their use of monetary policies to reflate the economy’’.
When combined with a greater push towards fiscal stimulus and inflation targeting, a likely outcome according to BOFA is one of much higher interest rate volatility that breaks the “decade-long bullish combination of minimum rates and maximum profits” and signals a big peak for asset prices.
Notably, central bankers are calling loudly for greater fiscal spending, as their lack of monetary ammunition leaves them ill equipped to combat the next significant downturn.
This week, that message was sent by Jay Powell when the Fed chair spoke before a Congressional committee in Washington.
There are plenty of questions as to the potency of fiscal spending in the future and whether it does ultimately boost productivity and growth rates for the broader economy.
Markets will eventually prosper from a boost to long-term growth and productivity.
One risk cropping up in conversations with bond investors of late is of central banks coming under political pressure and monetising government spending in the years ahead.
Another consideration among central bankers is whether to accept higher levels of inflation, to make up for missing their 2 per cent targets down the years.
As Morgan Stanley argue: “Such an overshoot of inflation could pose problems for rates and, in turn, the valuation of stocks and the US dollar — making real assets attractive.’’
Little wonder that institutional investors are pushing into alternative real assets that includes building exposure to gold and other commodities.
Equities and bonds have spent a considerable and rewarding period swinging back and forth within a narrow range defined by monetary policy.
Contemplating a far greater pendulum shift should warrant the consideration of investors entering a new decade.
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