Equity markets have started the year in bullish mode with global equities rising a strong 2.7% in local currency terms last week. These latest gains were very much driven by developments in the US.
The news headlines may have been dominated by the storming of Capitol Hill by protesters. But for the markets, this was a mere footnote to the main event. Their focus was fair and square on the Democrats winning the two seats up for grabs in the Senate run-off elections in Georgia.
This victory leaves the Democrats with an effective majority in the Senate and Congress overall and the ability to push through further fiscal stimulus. A package worth $900bn or 4% of GDP was finally agreed at year-end and an additional stimulus, possibly as big, now looks likely to be passed in the next couple of months.
Together, these measures will provide the US economy with significant support near term while it struggles to contain the recent surge in infections. They will also give additional momentum to the strong rebound on the cards later in the year on the back of the vaccine roll-out. In short, recent developments have reinforced the optimism over growth that has propelled markets higher since November.
The wafer-thin majority the Democrats now have in Congress is in a way the best of all worlds for markets. It allows them to push through more growth-friendly policies but isn’t large enough for them to be able to implement much in the way of their more radical and market unfriendly proposals. Tax rises will be limited as will any healthcare reform and moves to crack down on the tech sector.
Even so, recent developments do have a potentially worrying aspect. Stronger growth is fuelling fears that inflation could pick up and central banks start to scale back their support. Along with the prospect of higher budget deficits, this is driving bond yields higher. 10-year US Treasury yields rose 0.2% last week to 1.1% and are up 0.6% from last year’s low.
This is important as US equity valuations are high. On one important measure, they are now higher than prior to the 1929 crash and have only ever been higher in the 2000 tech bubble.
Talk of bubbles is growing and there is even now talk of so-called ‘rational’ bubbles, if that isn’t too much of a contradiction. Very high equity valuations can be justified by the extraordinarily low level of interest rates at the moment. But if central banks were to take their foot off the gas and bond yields were to climb significantly, valuations would come under pressure.
We believe rates remain unlikely to be raised for another couple of years at least, so higher rates don’t present an immediate danger for equity markets. Still, their high valuations do leave equities vulnerable to any threats to the bullish base case of a strong rebound in growth.
The most obvious risks are virus-related – a delayed vaccine roll-out and/or the vaccines proving less effective to new variants of the virus. While we are positioned to benefit from further gains in equity markets, our positioning is mindful of these risks.
The UK merits a quick comment as it was a star performer last week despite the news of a mounting crisis in the NHS and possible intensification of the lockdown. UK equities gained as much as 5.6%, benefiting from the ongoing rotation away from last year’s winners and more expensive markets to the cheaper laggards such as the UK.
Rupert Thompson
Chief Investment Officer