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Taking a pause. After a strong start to April, which has seen consistent new highs for U.S stock markets on ever-improving economic data, U.S and global stock markets have been on pause over the last week. The so-called ‘Goldilocks’ scenario, of an improving outlook for corporate earnings against a background of low and stable interest rates, has come under pressure on several fronts.
Travel restrictions on some countries have increased, as the number of cases of Covid-19 in large emerging markets such as India and Brazil continues to rise. In the U.S, the Biden administration has begun spelling out the new personal taxes that it will push through Congress. There are concerns over high valuations in some sectors on Wall Street. In the eurozone, economic growth remains very weak in the south, yet Germany and the Netherlands are putting pressure on the ECB to ease its Euro 1.8 trillion Pandemic Emergency Purchase Program -which risks a premature tightening of eurozone monetary policy.
But this is likely to prove only a temporary pause in the recovery rally on global stock markets, with each of the above ‘problems’ probably fading and as investors focus on continuing strong corporate earnings growth.
In the U.S the sugar-rush of Biden’s March $2 trillion stimulus package will soon be felt in the economy. Asking the wealthy to pay more tax for further redistributive policies is likely to boost overall GDP growth, rather than contract it, if such policies put the money into the hands of those who will spend it. Therefore fiscal policy will boost corporate revenues and profits, in turn helping to alleviate concerns over stock market valuations. German and Dutch fears of inflation appear ill-founded, given that regional wage growth remains weak. The ECB appears determined to imitate the Fed in keeping interest and keeping bond yields low, so ensuring a robust economic recovery throughout the eurozone. Meanwhile, vaccination programs in continental Europe are accelerating after a slow start, and an easing of lockdowns and travel restrictions across the continent over the coming months is likely. This will go some way to balancing the negative news from South Asia and Latin America.
The above suggests that the recent weakness on global stock markets is a temporary pause in a recovery rally that has further to run. The VIX index of implied volatility on the S&P500 stood at 18 yesterday. This is a far cry from the 66 reached last March, suggesting little fear in the market of a correction.
But perhaps the key reason for stock market investor confidence is the ongoing, and often repeated, resolution of the Fed to hold down interest rates even as U.S inflation rises. The ever-sceptical bond market now appears to believe the Fed’s commitment to this policy, perhaps because it too sees current U.S inflation pressures as temporary. As a result, Treasury yields are now stable (with the 10yr at around 1.5%), after the significant jump in yields of February and March. Even recent strong retail sales data and March CPI inflation of 2.6% year-on-year (double February’s number) failed to move the Treasury market. Asset managers outside of the U.S, particularly in Japan, have reportedly been buyers of Treasuries which now offer meaningful yields compared to Japanese and many continental European bond markets.
Read the Business section of most newspapers and it seems easy to put a finger on where we are in the economic cycle. The global economic recovery has begun, led by China and the U.S (the U.K trailing, having suffered a bad second wave after Christmas). The IMF is forecasting 5.5% GDP growth this year, compared to a contraction of 3.5% in 2020. Chairman’s statements are bullish about the prospects for this year as lockdowns come to an end, and on stock markets the economically-sensitive sectors that were so unloved for much of last year have made a roaring recovery, with materials and energy amongst the leaders.
Meanwhile, interest rates are rock-bottom, unemployment much higher than a year ago while inflation is creeping up from a cyclical low. These indicate the early stage of an economic cycle.
Yet there are some anomalies that make this cycle different. Because central banks and governments have bent over backwards to provide support to the global economy over the last year, credit was not rationed during the downturn. Instead, cheap loans have helped keep companies alive that would otherwise have gone bust. Instead, the number of bankruptcies in the first quarter of 2021 was lower than the same period last year. An illustration is my local shopping street in north London: does it need so many coffee shops? The weak ones take pricing power away from the good, which limits the growth of the better-managed café. Normally, the weak would have gone to the wall during the downturn. These so-called ‘zombie’ companies will be a drag on the recovery of the good companies. In the U.S, the high yield corporate bond market is seeing a spike in defaults, defined as bonds trading below 50% par value. But, according to JP Morgan Asset Management, at around 6% the current level is around half that seen during the last wave of defaults in 2009.
The price we pay for loose central bank monetary policy is not inflation, it’s misallocated capital. It is not only in the corporate landscape where excessive availability of cheap credit -done with the best of intentions by policymakers- has created distortions. The liquidity cycle (ie, the availability of credit) is running out of synch with the economic cycle. Financial markets are seeing ‘late cycle’ events, that we usually see at the end of an economic cycle, not the beginning, because the last economic cycle avoided a period of interest rate hikes and the availability of money went from ‘easy’ to ‘super easy’.
There is evidence of late-cycle liquidity misallocation everywhere. This year we have seen the Reddit/ GameStop saga of February, the 30% over-pricing of the Deliveroo IPO in March, the fad for investing in shell companies (SPACs), the blow-out at the hitherto unknown Archegos family office in the U.S (that eerily echoed the failure of LTMC in the late 1990s). Echoing the 2008 financial crisis, complex financial products engineered by Greensill Capital and commercial banks have come unstuck. It is unusual for such stories of misallocated capital to be appearing in the upswing of a new economic cycle, they have usually revealed at the end of the previous cycle. But the economic and liquidity cycles have ceased to be synchronised. We can expect more such stories as long as central banks everywhere underwrite policies allowing money to be both cheap and plentiful. It is the price we will pay for central bank support of the economic recovery.
As always, investors should be as diversified as possible in order to maximise returns relative to risk (ie, volatility). This means geographical, sector and asset class diversification.