In the Fed we trust?
Markets could have a very long way to fall if the Federal Reserve’s policies aren’t the answer
Stop. Rewind. Erase. Earlier this week the S&P 500 in the US hit a record high, eclipsing the previous zenith achieved back in that ancient epoch that historians refer to as February. As far as the markets are concerned, it’s as if the last six horrendous months were nothing more than a bad dream. How can this be?
The performance of any equity index moves in line with investor expectations about the future earnings of the constituent companies. Have investors really lived through the past few months – the deadly pandemic sweeping the globe, hundreds of thousands dead, millions confined to their homes, whole economies placed in suspended animation, business models vaporised – and concluded that the future prospects of US companies have not just been unaffected by the global pandemic but actually improved? Really?
No, not really. There’s a logic to the market recovery, but it still leaves us with some highly troubling unanswered questions.
As Toby Nangle at Columbia Threadneedle points out, market prices are not just a view of future earnings, inflation and fiscal policy. That’s because they don’t occur in a vacuum. Prices are formed within a financial system and investors have to keep a very close eye on the system itself – like scientists who have to make sure their beakers don’t break when they’re mixing dangerous chemicals.
US equities went from peak to bear-market territory in just 15 days – an achievement that took over half a year during the 2008-09 financial crisis. Part of the reason why asset prices plunged so precipitously was that investors were worried there was a very real danger the market sell-off could cause the financial system to implode. Weird things started happening to the prices of all sorts of assets. Subsequent comments by global regulators – not least Andrew Bailey, the Governor of the Bank of England – have shown they were right to be worried.
Thankfully policymakers spotted the same potential catastrophe and moved with both startling speed and unprecedented coordination. The kind of measures that central banks rolled out over several months during the previous financial crisis were deployed almost instantly and a few others were added to the mix for good measure.
At this point, the fear of the whole system going pop started to abate and the markets began to recover. As Nangle says, part of the subsequent rally can be attributed not to hopes that economic growth and future corporate earnings will pick up, but rather that the market disorder would ease. And it has.
The huge stimulus provided by central banks has also helped to lift asset prices further than relief alone would have done. Sure, central banks are mostly buying bonds, but this provides the wind beneath the wings of almost all asset classes.
The whole episode has confounded all those who thought that central banks were running out of room for manoeuvre. There were plenty of us who thought that interest rates were so low and central bank balance sheets were so bloated from a decade of quantitative easing that, when the next crisis hit, there’d be nothing left in the locker. That was wrong. The key this time was the speed with which central banks moved and the degree of coordination with government treasuries.
Nevertheless, the recovery has been incredibly lopsided. The market as a whole is back where it was in February, but nearly two thirds of companies aren’t. Big tech stocks such as Facebook, Apple, Amazon, Google’s parent company Alphabet, Netflix and Microsoft have hit stratospheric valuations – Apple alone is now worth more than $2 trillion, a fraction less than the whole of the FTSE 100. But
‘Central banks are buying bonds, but this provides the wind beneath the wings of almost all asset classes’
the majority of US stocks are still struggling, with the average constituent of the S&P 500 about 7pc down on where it was in February.
There’s another troubling aspect to the recovery. As Mark Haefele at UBS points out, when equities are rallying, you’d normally expect yields on US Treasury bonds to be rising. But throughout the dramatic recovery in share prices, Treasury yields have barely budged. Haefele describes this as the dog that hasn’t barked and believes the culprit is market expectations that the US Federal Reserve will keep interest rates low out as far as the eye can see.
This suggests, in UBS’S opinion, that the actions of the Fed have become a more important factor for the price of riskier assets – such as equities – than anything else, and that includes the coronavirus pandemic.
Certainly equity valuations have risen to nosebleed levels at a time when the economic outlook is, at best, highly uncertain. The cyclically adjusted price/earnings, or Cape, ratio of the S&P 500 recently climbed to about 31. It has only previously been higher just before the Great Crash of 1929 and the bursting of the dotcom bubble in 2000.
That said, long-term interest rates have never been lower. All things being equal, low interest rates justify higher equity valuations partly because fixed income investments become less attractive in comparison to equities and partly because big companies can access cheap financing.
But that means there’s now an awful lot hanging on the Fed. As UBS’S Haefele says, investors face a stark choice: “They can go back to the economic textbooks and the historical relationship between yields and growth, in which case the bond market is telling them the growth outlook is terrible and equities are due for a substantial correction. Or, they can believe that markets are now more heavily influenced by Fed policy than growth or inflation expectations.”
At the moment they appear to have plumped for the latter option. But, if they’re wrong and the Fed disappoints them, equities have an awfully long way to fall.