Head of Equity Strategy
The last 24 hours have sent global equities higher and if this continue until end of month we will see US equity valuation creep into dot-com bubble territory for the first time in 20 years. All engines have been fired up by policy makers and it looks like equities will continue to rally into 2020. Let’s go through the different factors at play.
The Fed revealed silently yesterday that they are injecting half a trillion dollars into the financial system in order to avoid a cash crunch into year-end and spiking repo rates. In other words, the Fed put is strong and alive. We are basically just waiting for the Fed to increase its monetary operations to coupons which means real QE. At the same time, other central banks are also easing pushing down rates improving the spread between fixed income and equities, which means equities look more attractive as long as the economy doesn’t go into recession.
Fiscal impulse is increasing with both China and the US increasing fiscal deficits. Japan just announced that they are increasing spending following South Korea’s decision a month earlier. United Kingdom will most likely increase spending next year under Boris Johnson as the new Conservative party is not a believer in austerity and balanced budgets. It simply doesn’t buy voters. The EU is thinking about green bonds and many EU countries have indicated higher spending next year. Overall, all fiscal engines are ramping up rpm (revolutions per minute).
The UK election clears the path for a Brexit which lowers uncertainty and increases the odds of investments coming back to the UK. But the real take away from the election is that austerity will be left behind by Boris Johnson. That’s the real change here.
OECD’s leading indicators are showing the global economy is turning around. This is good for profit expectations in 2020 and the recovery phase in the economy is typically the best period for equities against bonds with an average 9.4% excess return for equities over the period.
With all the positive factors just highlighted our view is that equities will continue to rally and that we are most likely setting us up for a 1999-2000 scenario with equities melting up before things turn into an ugly correction. Our main focus now is watching the key government bond yields. We know from the past that when yields go up too much it creates a breaking point for equities. The average G7 10Y yield is 0.79% and the breaking point seems to be around 1.5%. This leaves plenty of room for bonds to fall and equities to move higher agreeing with historical observations of equity outperformance during the recovery phase.
But with more gains in equities come elevated equity valuations and especially US equity valuations look stretched, but more on that in January. With G7 10Y yield at 0.79% and global corporate bonds yield at 2.2% there is no attractive liquid alternative to equities. So for now enjoy the ride in equities and watch those rates.
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