The comment "Axiom: low rates for a long time!", By Andrea Delitala, Head of Euro Multi Asset, and Marco Piersimoni, Senior Investment Manager of Pictet Asset Management
The United States is officially in recession. The longest expansion cycle in history has stopped after 128 months of growth without pauses, from June 2009 until today. To decree its end is the US National Bureau of Economic Research, which identified the peak of economic activity in February 2020.
On the other hand, the signs to that effect had been evident. The unemployment rate, which in April had touched 15%, would have been enough, marking the loss of over 20 million jobs in a single month (considering also the "latent" unemployment due to the fact that many people employed could not however work, it reached almost 20% of the population).
On the labor market, however, two elements today lead to a certain optimism. The first is that, unlike what happened during the last crisis (2007-2009), the surge in unemployment seems in this case mainly linked to temporary layoffs, which the economy should be able to reintegrate into the restart phase. The second is the surprisingly positive figure recorded in May. In fact, non-farm payrolls reported the creation of 2.5 million jobs in May, despite operators expecting a further reduction of over 7 million jobs. As a consequence of this, the unemployment rate, projected to 19% of the population, has actually dropped to 13.3%, once again demonstrating how complex it is at the moment to make economic forecasts.
The data on the US labor market in May, if verified, seem to confirm the famous "V" trend of the recovery, already shown by the Chinese economic data (where the activity has in fact returned to its normal levels) and in part also from some American indicators, both on the production side (manufacturing SMEs) and on the consumption side (demand for cars). In order for this dynamic to continue, however, it appears absolutely necessary to avoid a second wave of contagions, a risk hitherto averted but which is starting to manifest itself in some countries, such as in China. Otherwise, the "V" could soon turn into a "W" with structural damage to the global economy, against which not even the accommodating attitude of central banks and governments could do much.
These, for their part, are already making use of most of the weapons available to them, so it would be difficult to hypothesize huge new stimulus measures in the event of a failure to return to normal. Confirming the ultra-accommodating line, the Federal Reserve this week announced that it is not even thinking about raising rates (not even thinking of thinking about raising rates) at the moment, shifting this possibility to a time indefinite plan , previously excluded for the next 2 years. A statement that led operators to hypothesize nominal rates far from the long-term equilibrium value (neutral rate of the Fed, estimated at 2.5%) for a long time (the projections for 2025 are at 1%). Even more significantly, real returns, which are truly relevant for the economy and financial assets, are negative even on very long maturities, with 10-year ones equal to -0.5%. Furthermore, we are convinced that, once the output gap that opened with the COVID is closed, inflation will at least be able to get closer to the target of 2% (even exceeding it will be tolerated) and that central banks will ensure that the increased inflation (current and expected) is transferred entirely to nominal rates. In this case, real rates and yields may remain stable or even fall. This is a scenario that would amount to further economic stimulus as well as a cure-all for debt sustainability for both the public and private sectors, which will have gone further into debt.
As mentioned, however, at this point the central bank has relatively few unused solutions in its arsenal: among these, the most likely one and which is already being discussed is a Japanese curve control program, particularly effective for acting on the most expiring deadlines long, possibly as an alternative to QE that will not be able to continue forever, even in the USA. At the moment the Fed guarantees the substantial monetization of the public deficit, leaving more room for fiscal maneuver for the administration. It is no coincidence that the Treasury is doing this front-loading of public debt: taking advantage of the favorable conditions guaranteed by the central bank (low rates and massive purchases), the Government is issuing Treasuries to a greater extent than its current needs, setting aside the resources it will need during the year (approximately $ 4,000 billion overall, just under 20% of GDP). The same debt monetization process is taking place in the Old Continent, where on 4 June the ECB decided to expand the PEPP emergency purchase program by an additional € 600 billion (now from € 1,350 billion overall) and to extend it at least up to at the end of June 2021. As a result of this, the share of debt / GDP held by the central bank is expected to rise from the current 23% to just under 30% of the total by the end of the year, thus going to cover a large part of the issuance of new debt which individual Member States will inevitably have to resort to.
At the same time, the Next Generation EU plan, the old Recovery Fund, is being defined in the region, the long-awaited collective intervention that represents a real turning point for the community's political set-up. In its current formulation, the Next Generation EU involves a net transfer of resources from the countries with the greatest margin of fiscal maneuver, Germany above all, to the most indebted countries and with the least possibility of acting through the levers of their public budget, Italy, Spain and on this occasion also France. A maneuver that goes in the same direction of the road taken in recent months by the ECB which within its purchase programs, temporarily deviating from the capital key mechanism, has bought the sovereign bonds of the countries in particular difficulty in greater measure (always Italy, Spain and France). An emergency measure made necessary by the different possibility of fiscal expenditure of individual States, but which cannot last long (in fact, the German Constitutional Court has already intervened to bring the ECB to order). In this sense, the new Recovery Fund will replace the central institution in the redistribution of financial resources within the region, although to see it at work it will probably have to wait for 2021. In the meantime, it is not to be excluded, for the countries more needy, the combined use of MES and OMT.
With central banks committed to keeping real rates low for a long time, it is not surprising that equity valuations have risen in recent months. Interest rates, in fact, impact on three different ways on stock prices and their fall does nothing but support multiples. First of all, they make up the discount rate of future cash flows (dividends), so that their descent only increases the present value of future dividends and, consequently, prices. Secondly, interest rates are one of the key factors that influence the cost at which companies finance themselves: also from this point of view, therefore, long low rates are excellent news for equities. Finally, from a purely financial point of view, they represent the first alternative to equity investments and their compression does nothing but increase the risk premiums; for these to return to levels close to their historical average (approximately 4.4%), stock prices must necessarily rise further, closing the yield gap between stocks (earnings yield, that is the inverse of the P / E ratio) and bonds ( real bond yield).
For the above reasons, in a context of long low rates, with equal profits, equity valuations are inevitably pushed upwards. Therefore, the possibility that we will see multiples on non-economic levels for a long time cannot be excluded. It is no coincidence that the markets that have experienced the greatest expansion of multiples in recent weeks are those characterized by more aggressive central banks (USA, UK and eurozone). In such a scenario, earnings dynamics will determine the evolution of stock market valuations. At this time, analysts' consensus expects earnings growth to improve between now and 12 months after the slump in the past few months. Therefore, analysts also seem to embrace the hypothesis of a "V" recovery. However, the uncertainty in economic forecasts is still high (as demonstrated, for example, by the surprising data of the US labor market) and the risk of a new wave of contagions weighs inexorably on the prospects for corporate profits.
Contextualising the uncertainty surrounding these forecasts, it can be useful to make a comparison. As mentioned, the mistake made by economists in estimating the latest US labor market data has been macroscopic. An error of over 10 million jobs, in statistical terms, is equivalent to an estimate error of 15 standard deviation. The American market currently trades at a price / earnings ratio of 23 times. The profits (in the denominator) are estimated: projecting an estimate error similar to that made by economists, we can say that the range in which the real P / E could be around is between 10 and 50. Certainly, not a great reference for make asset allocation decisions. To add alea to the context described, in the background the stumbling block of the American elections begins to emerge: President Trump does not lose too much consensus despite the errors (if nothing else of communication) in the management of the health emergency and the violent wave of protests in recent weeks , but Democratic candidate Joe Biden seems favored at the moment. His eventual victory, probably accompanied by a democratic control of Congress, could mean higher corporate taxes and a new phase of regulation, two factors not appreciated by the market.
Ultimately, the reading of the coming months appears to be surrounded by a series of risk factors that are difficult to predict, also because they are largely of an exogenous nature (new wave of infections). On the horizon, we have one big certainty: low rates still long.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/quanto-durera-il-trend-rialzista-delle-borse/?utm_source=rss&utm_medium=rss&utm_campaign=quanto-durera-il-trend-rialzista-delle-borse on Sat, 20 Jun 2020 06:05:30 +0000.