Too soon to call a top? All the world’s equity indices are on a tear. Till date there’s been an 8 day rally globally; The Dow Jones Industrial Index and the Nifty 50 have been climbing relentlessly since the middle of last year, the FTSE 100 has been charting steady progress to hit 7.2k, Shanghai and the Nikkei have been surging, the S&P index has seen an almost linear upward trend, even the staid Dax is flirting with all-time highs. Why would anyone turn bearish now?
Fig. 1: Global Equity Markets are on a one-way trip to the moon?
Source: Investing.com
The simplest answer would be: global conditions aren’t as rosy as they looked earlier. It seemed for a while that the appearance of the vaccine would lead to a disappearance of the virus and that global trade, employment and production would surge under the conducive conditions of low rates, ample liquidity and government support programmes for households, infrastructure and health spends. In short, it would be like a post-war boom when devastated economies spring back to life- especially when no physical infrastructure has been destroyed. It seemed that way at first with strong GDP growth numbers showing for the US, UK, the Euro area, Latin America excluding Venezuela and Turkey- even Singapore, Malaysia and the Philippines. But this is a false narrative given that these are just reflating back to original size numbers. That is, the economies which had shrunk due to covid inactivity, have just grown back into their old clothes. Assuming that there were equity valuations in place earlier which hadn’t accounted for a catastrophic slide in output and consumption of services then the current elevated valuations are taking into account a continuation of this remarkable growth rate apart from a continuation of low rates and high liquidity (which act as both opportunity cost as well as actual cost of leveraged positions).
Are those fair assumptions to make? Is it fair to expect elevated growth rates to keep happening? Well, in favour of this argument one could argue that the ultra-loose monetary policies being enacted are definitely creating a different set of criteria by which to judge asset allocation. Simply put, if your opportunities elsewhere offer lower returns then richer valuations are no longer unattractive. The Nobel prize winning economist Robert Schiller, whose work has been on empirical analyses of asset prices determined an ‘ECY’ level which was- in turn, derived from his CAPE (cyclically adjusted price to earnings) ratio and calculated the equity valuation vis-à-vis the real interest rate. This ECY basically expresses an equity market premium and is useful in considering whether markets are overvalued given the current yields on bonds. In December 2020 Shiller declared that stock markets were at their most attractive since the 1980s when yields were high and equity was low. But that was in 2020. What about now when the US indices are up 20%? At current levels the Shiller model as well as another model which looks at the equity market relative to the replacement cost of assets- known as Tobin’s Q both suggest that the US market would have to fall 50% to get to fair value. That is: without the loose monetary policies of central banks equities would be at a much lower level.
What is the prospective for rates and growth? For growth the list of countries with double digit growth hides the base effect- the shrunken GDP of last year. What’s important is the prospect for further growth after the lost ground has been regained. There we’re on shaky ground. In the last article we talked about Chinese growth prospects being poor compared to the US and the effect this would have on world growth given the size and centrality of the Chinese economy. The numbers for China show a declining growth path with August numbers in the contractionary zone for both manufacturing and services. But the US is facing a resurgence of Covid with the issue of masks and vaccines- no-brainers really, being so politicized that some Republican led states showing higher death rates than the peak last year before the arrival and widespread availability of the vaccine. This is reflected in the abysmal Non-Farm Payrolls data for August that came out last Friday and- at 235 thousand, is far lower than the market expected.
Perversely, the equity market rose because that represented the likelihood of a slower tapering of the liquidity measures by the Federal Reserve. This is no longer investment based on expected returns but punts on the likelihood of central banks invoking some variant of the ‘Greenspan Put’ (or ‘Bernanke Helicopter Money’ as well in this case). If the news is bad for the economy then the news is good for the stock market continues to be the case.
So, the prospects of growth look dim from the two largest economies in the world. Even Europe is not immune from the bleak outlook. Goldman Sachs has cut its forecast for US growth from 6% before the employment numbers to 5.7% after. This week also sees the end of a lot of employment support payments in the US which will act as a further dampener in consumer spending. Not good signs for the economy though this could delay the tapering of liquidity assistance from the US central bank which has a bloated USD 8 trillion dollar balance sheet now.
If growth is going to be a struggle then the only silver lining is rates and this is where the problem lies. Governments have come to the conclusion that- with engineered lower rates, their loan repayment costs aren’t so onerous and have gone gung-ho in issuing debt. The market is awash in debt issues even as some central banks are starting to look at raising rates to head off inflation. The anecdotal evidence is that some persistent rising input costs are going to drive up prices sooner rather than later. Production and supply bottlenecks because of Covid are behind this. And this is the case from China to India, New Zealand to the US. Nouriel Roubini, who predicted the 2008 financial crisis, is now predicting a period of stagflation with lower growth and many countries getting caught in a debt trap. And he’s predicting that it isn’t far off when the chickens come home to roost. The fear is real and the central bankers and the markets know it: it is all down now to the timing of the liquidity taps being turned off. The minute that happens the equity markets are likely to come down hard. Until then, markets seem to be happy ‘collecting pennies in front of a steamroller.’