The financial markets' tug of war
Chief Investment Officer
Summary: The day we had the biggest attack on the US Democracy in modern history the S&P 500 and Russell 2000 Indices made new all-time highs. We all know that the market narrative has been a challenging one to follow through the course of the Covid-19 pandemic and as we hope for a successful vaccine rollout and recovery. Here, Peter and I attempt to line up the pro and cons of the stock market from its current perch, after a blistering rally in most world markets.
- co-written by Peter Garnry, Head of Equity Strategy
The list is not final or even closed to complete, but a guide based on my experience as a macro veteran with thirty years of market experience on my back, and a younger, if barely Millennial superstar, our equity strategist Peter Garnry.
We do this analysis based on the US markets, as they are the biggest in size and liquidity and as the US has the strongest fiscal and monetary potential combination. Bear in mind that the Saxo Strats team is not generally in the business of calling the next 10% of the market or the next swing trade, but to facilitate information and perspectives on valuation, news, fundamentals and the market structure. We urgently feel the market presently represents more risk than reward, but that is only our assessment and our timing and analysis could certainly be wide of the mark, so we will list how we see and hear the arguments from both sides of the market.
Arguments in favour of market continuing higher
- Asset Allocation: There is only one asset class with positive risk premia: Equities (and equity linked instruments).
- Monetary policy: Fed says the next hike, at the earliest, won’t arrive until 2024 and the size of QE support is “whatever it takes” until full employment is near.
- Fiscal Policy: The President Elect Biden talks about $3 trillion of stimulus, if so, we will see the present level of 20%+ of US BDP fiscal spending continuing for the next two years at minimum
- Insurance policy: The FED and the government will protect investors until full employment is reached, which is defined as at least the same level as prior to pandemic.
- Vaccine roll-out: Normalized markets, pent-up savings boosting the economy, earnings, and growth.
- Technical: The market continues to bounce off, find support, from technical levels like 100-day moving average.
Market is going lower arguments
- Rate Sensitivity: In world where supply in constraints brought by the pandemic and underinvestment in physical infrastructures and where inflation has been subdued by monetary policy, the risk becomes a higher interest rates level, even if only at the longer end of the curve at first. Saxo Strats sees a greater than even risk of higher than expected interest rates and with it a risk to the stock market through high risk sensitivity in technology and speculative stocks without earnings. Leverage has never been higher relative to earnings.
- Valuation: Whatever metric used historically is redundant as zero bound interest rates and almost unprecedented intervention from central banks invalidate their meaning. Valuations are rich, extremely rich. Astronomically rich for some companies. The market “loves” companies without earnings and transparency because they are unaccountable relative to “real world” of earnings. It’s simply a narrative, or story-telling, and who doesn’t love a bit of HC Andersen?
- Real Economy: The disconnect between the real economy and markets will become an issue. Stock market is sub-group of overall GDPs, it can marginally outgrow on its own, but is limited by overall economy. We see inequality as political driver and through its misguided allocations into small pockets of government pet projects like Renewable energy. Government are heavy misallocators of money and government size of economy is growing everywhere!
- End of cycle. Time! It could simply be time for end of cycle, remember the last two years rise in stock market has not been supported by earnings or productivity improvements. Long term return is based on productivity innovation and earnings. Market is fueled by cheap money alone.
- The January 6th storming of the Capitol as a 9-11 like event which marks a historic turning point for markets and the open model of FIAT money. A full blown attack on democracy is an effort to undermine property rights and law and order upon which our rich culture, education and society is built. Fifty years ago in the 1970s we initiated the end of the gold standard, China opened up, we discovered dependency on energy, we moved away from excessive government involvement and bad hair styles. Now we are trying to close down our relationship with China, seeing the fiat money cycle coming to a scary end, replacing fossil with renewables and we are losing our hair.
The more extensive arguments for main points can be found below:
Asset Allocation. Looking at the stock market from the point of allocation, means asking yourself what is the potential return from owning the asset, equity, over time and how does that compare to the alternative?
The NASDAQ Equity Risk Premium is 360 bps vs. a “risk free” premium of -100 bps in real yield of 10-year US treasuries. The negative real yield is how the US forces us all to “play the game” of being long the stock market, as it’s the only asset right now with positive risk premium we can harvest. Part of the story is that we have higher savings level today than in prior cycles, and a need to invest this money. This means equity becomes the favoured destination for investment, and with-it equity linked products like Private Equity, SPACs and credit bonds. Simply, if you are financial planner the only way to access positive return is in the equity market.
Monetary and Fiscal Framework. Fancy words, but it really means: What is the price of money and for long? How much money will the government use to increase or protect demand and finally how willing are they bail-out risk takers if things turn ugly? The answers are simple: The price of money is effectively zero and until 2024 if you believe in US central bank, the Federal Reserve.
On average, the government spends somewhere between 10 and 30% of GDP to support growth in 2020, for 2021-2024 the support will continue but eventually drop to the 3-8% level on average, although the implicit “Fed put” on markets, or risk-free guarantee, is infinite in size and time right now, at least as long as we are not back to employment levels seen prior to pandemic.
Vaccine. There is widespread hope that a Covid-19 vaccine roll-out in 2021 can normalize the underlying real economy and increase earnings, employment, and margins. The risk is that new mutations of the virus will dilute our attempt to normalise our society with the first-generation vaccine.
Rate Sensitivity. Some of the largest US publicly listed companies are trading as bond proxies because of their earnings stability and low government bond yields. As US technology stocks have come to dominate equity markets during this low yield regime, interest rate sensitivity has gone up. According to our simplistic calculations a 100, basis points move in US yields could lead to a 15-20% market decline just from repricing future cash flows. For technology stocks outside the Nasdaq 100 where speculation and valuations are even more elevated the sensitivity is even greater. Corporate debt to GDP in the US has increased from 46.2% in December 2019 to 51.5% in December 2020, significantly exceeding the levels from before the 2008-09 financial crisis, which means that the entire US private sector could come under financial stress at much smaller changes in the interest rates, creating financial turmoil.
Valuations. Many conceptions about macroeconomic policies, monetary policy and financial markets have been rewritten over the past ten years. The closest we can get to a “law of investing” is that the higher the valuation of an asset when we invest in it, the lower the future return will be. US equities are now priced at 23.2 times expected earnings over the next 12 months. That level is taking us closer and closer to the dot-com valuation peak from December 1999 at 25.7 times expected earnings over the next 12 months. Monetary policy has pushed financial markets into one of history’s greatest asset bubbles and while the timing is difficult, history suggests that future returns will be low and that at one point the speculative feedback loop will run out of steam when investors stop buying. Enough awareness of dot-com valuation levels and low expected returns could at one-point reach psychological inflection point where the crowd reverses its view and then things escalate quickly.
Social Inequality/disconnect to real economy. For forty years politicians and companies have been optimizing GDP growth and profits over the health of the population and the environment. This doctrine has driven globalization, lower prices, lower labour union participation and no wage growth for the lower 50% of the population, with higher health care costs squeezing the middle class. These forces created the “Trump movement” and fuelled an epic bull market in equities due to explosive earnings growth from globalisation and technology but drove a widening wedge between financial markets and main street. Inequality is at its highest since 1929 with no end in sight. If policymakers don’t change their objective to lifting the lower 50% of the population in the western world – particularly in the US, history tells us that social unrest will only get worse until wealth and income is transferred by force rather than peacefully.
There is ample evidence to be on both sides of the market. We think 2021 will offer great opportunities and returns, but traders should tread with a healthy respect of where we are in the cycle, exercising prudent money management, proper sizing of trades and the recognition that good luck is always some portion of returns. We wish you all the best for 2021.
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