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.
Lastly, the big news yesterday was the apparent breakthrough
on the US-China trade deal “first phase”, but since the US media highlighted
that Trump had signed off on the deal the Chinese side has been completely quiet.
While it looks like a temporary truce and small tokens by each side in the
trade war, the past two years have taught us that things can change fast. We
don’t really know until Sunday evening where we stand on the trade issue.
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.
