The short-term pull-back in stock prices last week on the back of persistent virus concerns in the US and elsewhere shows the market remains jittery despite the massive run-up in prices since late March. May data from China showed a relatively fast rebound on the supply side of the economy, but a much slower take-off in consumption, suggesting a ‘reverse square root’ kind of recovery for economies rather than the ‘v’-shaped one markets have been pricing. We therefore maintain our cautious tactical stance on equities. Further short-term challenges lie ahead such as Q2 corporate earnings, although upcoming vaccine trials could diminish fears about a ‘second wave’ of the pandemic in the coming weeks.
The sharp decline in markets on Thursday was also due to the Fed. Against a background of gloomy predictions, Chairman Jerome Powell committed to rock-bottom rates until at least 2022. Powell seemed unconcerned about the risk of ‘moral hazard’ stemming from accommodative rate policy. Back in 1996, Alan Greenspan’s allusion to “irrational exuberance” was taken as a hint that the stock market might be overvalued. Back then, the aggregate forward 12-month price-earnings ratio for the S&P 500 was around 16x, compared to over 21x today. However, there is a crucial difference: back in the 1990s (and at the time of the bursting of the dot-com bubble in 2000), 10-year Treasury bond yields were over 6%, compared with below 1% today. Valuations are high, especially for growth stocks, but do not look so expensive relative to the discount rate. As long as bond yields remain low, higher equity multiples can be justified.
An important European Council meeting is being held this week, during which we will see how strong opposition is to the European Commission’s proposals for a symbolically important recovery fund that includes non-refundable grants. Even if no consensus is reached this week on the fund, we believe Angela Merkel is eager to leave a positive political legacy, meaning there is a good chance we move forward on burden sharing in the euro area. This would make euro assets fully investable again.
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