By Stephen Jones
In January, I encouraged readers to consider holding on to equities even after strong gains
in the fourth quarter of 2020, the imposition
of a fresh economic lockdown, investor complacency manifest in lofty valuations and vaccine delivery risks.
Global equity markets are up eight per cent year-to-date; so far, so good. In the near-term markets should perform well, thereafter caution is warranted.
Flattered by the impact of widespread lockdowns last spring, year-on-year comparisons in economic data released over the summer will suggest developed economies are booming.
Once this first-wave of pent-up demand is released, what happens next is key.
Bulls hope to see a broader version of what is happening across residential property markets
– TV presenter Kirstie Allsopp, star of property show Location, Location, Location, judges them scarily heated.
Bears expect savings rates to remain high and consumption to fall back.
In isolation, equity markets look “scarily” expensive. Lofty equity valuations, however, reflect exceptionally low risk-free bond yields, tight credit spreads and now, significant fiscal relaxation. In context, risk market ratings can press higher.
JP Morgan recently analysed the major risk markets of the past 40 years, noting that every business cycle generates at least two bubbles.
Markets have tended to withstand truly extreme valuation ratings for upwards of a year on average – occasionally well beyond, and even if a market implodes, 80% of bubbled markets go on to make fresh all-time highs in the next business cycle. In short, bubbles are common and while investors can be early, they are rarely wrong.
Markets are always shaped by central bank policies and they, in turn, are shaped by the inflation outlook.
Over the past decade, US consumer prices have undershot the US Federal Reserve’s target. Persistently low inflation, even after the monetary largesse that followed the credit crunch, has launched a new era of policy accommodation reflected in the US Federal Reserve’s adoption of an average inflation target (2%). US 10-year bond yields are currently 1.6% suggesting that investors, leaning on experience, doubt the Fed can deliver the 3% inflation needed over the next three years to hit the inflation target.
Central banks have shown that, when it comes to cash, easing supply may not raise trend economic growth, lower unemployment, reduce inequality and improve living conditions.
Money might be available in infinite supply and at zero cost, but private individuals and companies remain reluctant to consume/invest
– unless it is to buy financial assets. Since the great financial crisis, we have lacked a buyer
– of goods and services – of last resort.
Enter big government, led by the US. President Joe Biden’s latest fiscal plan proposes spending about $4 trillion over the next decade; alone, that’s one-third of median income for every man, woman and child. An objective in itself, higher inflation will be the inevitable result of this unprecedented peace-time fiscal expansion. The actual form of inflation we get will sit somewhere on a continuum between debasement – to the cost of everyone (Argentina), and a powerful wage-price spiral – to the cost of savers.
These extreme possibilities are not academic considerations. Remember Covid-19, bad things happen.
The bond market is the punchbowl that sustains the revelry, and it will determine when the party ends. While US yields have risen this year, they remain well short of the equilibrium level (2.5%) implied by Fed forecasts. A rapid move through this level on buoyant economic data, should challenge risk markets by tightening US, and global, financial conditions but it
may take more than central action to keep bond bears in check.
Advocates of unfettered fiscal expansion see early rises in taxation as the way to keep economic conditions orderly. Unfortunately, history suggests that governments overspend
and under-tax; it is moot whether today’s politicians have the skill, wisdom and moral
fibre needed to act prudently.
When the froth fades and we start to look
into the prospects for 2022/3 we should start
to get a better idea of whether those investors currently blowing bubbles fully understand
the implications of this new policy regime
or are merely impatient. In the meantime,
spring is here.
Stephen Jones is chief executive at Aegon Asset Management UK.
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