US equity markets are close to all-time highs but sold off 2-3% in the first week of May after Janet Yellon, US Treasury Secretary surprised markets by saying rock-bottom interest rates might have to rise to cool the rapidly recovering economy. Higher interest rates are bad for stocks since
-higher bond yields make investing in bonds relatively more attractive versus stocks
-higher interest rates/bond yields raises the cost of corporate borrowing
-higher interest rates result in lower present day stock valuations as analysts discount future earnings using higher interest rates
Indeed, it is the technology focussed NASDAQ stocks that have struggled more this week as such growth stocks pay almost zero dividends so are more affected by higher interest rates.
Investors have debated for all of this year will US /global inflation make a return after a surging economic recovery after unprecedented central bank support and fiscal stimulus? The Joe Biden administration has already approved a $1.9 Trillion stimulus plan and is working on a further one for $4 trillion!
If inflation resurfaces then that will lead to higher interest rates. The 10-year US bond-yield has already risen from 0.90% Yield-to-Maturity to 1.60% today (although it did reach 1.70% a couple of weeks ago).
Inflation Protected US Government Bonds are pricing in an average US inflation rate over the next 10 years of 2.4% – above the US and many central bank’s 2% target.
However, Jay Powell of the US Federal Reserve, although acknowledging inflationary pressures due to strong economic recovery, expects any uptick in inflation to be temporary and their policy priority is to restore the US economy to pre-pandemic employment levels which we are still some way below.
Investors have further debated for months what will prompt the US central bank to reduce its $120 Billion a month of bond purchases begun in March 2020 – such purchases directly increase the bank’s ability to lend and therefore the money supply.
Another concern for investors, especially US, is stock valuation levels. The US equity risk premium, the extra return investors can expect for buying US stocks versus risk-free government bonds, has fallen to its lowest levels of the past decade by some measures, as the fiery stock market rally stretches valuations.
A separate measure shows the benchmark S&P 500 index is priced at almost 22 times expected earnings over the next year, compared with around 18 times before the pandemic began. During the past year, US equity markets have rallied on the back of a swift economic reopening. While earnings expectations have risen at the same time, they have been outpaced by the jump in stock prices.
At the end of the day, how do you price a stock market experiencing a rapid economic recovery the outcome of which is still Covid-19 dependent?
Non-US stock markets
We live in a global marketplace with the US economy being the world’s largest and a key driver in the global economic recovery so US stock market behaviour significantly influences most of the world’s stock markets. European stock markets are performing well as Europe achieves greater success with its vaccination roll-out. Asia is of course lagging behind.
The UK FTSE 100 index remains about 10% however below its all-time high but Brexit has been an additional consideration to COVID. The Bank of England revised up its economic forecasts this week rendering the possibility that it will set a negative interest rate this year once again. The Monetary Policy Committee revised up its 2021 economic growth forecast to 7.25 per cent in the May monetary policy report, from 5 per cent in its predictions three months ago. This more rapid recovery will likely lead to a slower recovery growth in 2022.
Foreign Exchange
The DXY Dollar Index is weak trading at 91 versus a 12-mointh range of 89-101. With short-term US interests at zero and the world a safe place the demand for US Dollars is not there.
Commodities
Industrial commodities such as nickel, iron ore and copper are at multi-year highs as the global economy powers ahead. Timber prices too (essential for building houses in the US have) seen prices double in 12 months. Oil too, strong at $65 dollars per barrel. There is talk of us entering a ‘commodities super-cycle’ of rising demand/prices.
Gold, which has little industrial use but bought in uncertain and inflationary times, is trading at $1,800 per ounce. Strong but down from all-time highs of $2,050 reached in July 2020.
