Despite positive macro and micro momentum, investors are starting to worry about the strength of the current rally, now a year old. There are more and more stories in the media on the ‘dangerously high markets’ theme, with accompanying parallels drawn between now and the early 2000s or 2007-08. Over and above the magnitude of the rally, which is clearly disconnected from economic reality, market sentiment is particularly striking. The FLIPO (Free Lunch at Initial Public Offer) of the late 1990s has given way to FOMO (Fear Of Missing Out)… does this mean that the situation is about to deteriorate in the same way as it did after 2000 or 2007? We are not at all convinced that it will.
Government bond yields appear to have bottomed out at the end of 2020, when 10-year rates were negative in many countries and at an all-time low of 0.5% in the USA. Rising prices for government debt naturally affected the rest of the bond market, from investment grade to the high-yield segment: spreads in the latter are at record lows in the USA and Europe. But we should not rush to conclusions. Nominal yields may never have been as low, but this is not true of real yields, and certainly not at the long end. We believe that nominal yields on government and corporate debt will remain at or around where they are now for some considerable while yet.
Although a number of signals for equity markets seem to suggest overheating, especially when compared with previous episodes, we are not convinced on that count either. For one thing, microeconomic momentum is extremely positive, which is bringing the price to earnings growth ratio back to pre-Covid, more reasonable levels. For another, and in contrast with the past, the world’s biggest financiers are now clearly keen to support equity as well as bond markets. And as the relationship between the size of the Federal Reserve’s balance sheet and the S&P 500 demonstrates, this matters. So while the upside for equity markets may now look limited, given how far they have already rallied – especially on Wall Street – risky asset prices have every chance of stabilising at around current levels worldwide.
The US corporate results season is ending on an impressive note. Almost all S&P 500 firms have announced their figures (98%, to be exact, or 495 of them), and 87% have posted earnings per share higher than analysts expected. This is the highest percentage recorded in the FactSet database, which for this variable goes back to 2008! Over the past five years, on average, the percentage of positive surprises has averaged about 74%. Moreover, aggregate earnings for the S&P 500 in Q1 are expected up 52%, compared with a 23.8% increase expected at end-March and 15.5% expected at the end of December. If realised, this would be the sharpest gain since the 55.4% reported in Q1 2010.
Our valuation model indicates that US markets need to consolidate in the short term, however. If interest rates stay where they are now, the correction would have to be in the 9-10% area. Our scenario that takes account of the fact that tax hikes will dent future profits among US firms from 2023 onwards (a scenario that does not appear to be priced in yet) suggests that the correction should be around 14%, again with unchanged interest rates. The consolidation would have to be only 8% in the event that long rates eased to 2%. We therefore continue to urge caution on US equities. The euro zone is on a very different trajectory. Our model suggests that European equities are fair value at the moment, irrespective of the scenario. It follows that we would overweight European equities against their American counterparts, just as we recommended last month.
