As it has been a quiet week so far on the economic data front, we thought we would address the issue which has recently appeared in many of the business pages of the press: are equity markets in a bubble that is about to burst?
This has been prompted by repeated claims by Jeremy Grantham, the Chief Investment Strategist at GMO (a US asset management company) that equities are in the final stage of a speculative bubble that will burst within weeks.
We have lived through sufficient equity market crashes and financial crises over the years to easily pooh-pooh Jeremy Grantham’s claims by simply stating that he can’t be taken seriously as he has been making this claim for several months!
However, we are also experienced enough to know that this would be foolish – as the proverb goes, “every dog has its day”.
Consequently, we would sooner explain why Jeremy Grantham believes we are in a bubble and then allay his concerns.
Ultimately it boils down to him believing that share price valuations have become excessive and dependent on low interest rates (yields) and his belief that interest rates will soon start to rise sharply.
While we accept that it would be simple to conclude that after last week’s US Senate run-off elections in the state of Georgia, which flipped control of the Senate and gave the Democrats control of both houses of Congress and the White House, it is now easier for Joe Biden to pass the mother of all fiscal stimulus packages to stimulate the US economy.
However, that doesn’t simply mean that the Fed’s (the US central bank) stimulus job is done and policymakers can start to tighten monetary policy by ‘normalising’ interest rates because:
- the Democrats margin of control in the Senate is only wafer thin, meaning that Joe Biden is unlikely to be able pass anything very radical;
- what the right hand gives, the left hands takes. While a big infusion of fiscal stimulus would help the US economy (and the global economy – as the US has the largest economy in the world) get through the turmoil of the coronavirus outbreak, unfortunately after every meal in a restaurant you eventually have to pay the bill – and Joe Biden has stated that he would like to reverse Donald Trump’s tax cuts to pay for the stimulus, which of course would dampen the benefits of the fiscal stimulus;
- Joe Biden could introduce stricter lockdown restrictions to slow the spread of the coronavirus, which will also slow the economic recovery.
In addition, towards the end of 2020 the Fed changed its inflation target from 2% to one that averages 2% – which means that they will now allow inflation to overshoot 2% to make up for the time it has spent running below 2% (and as we previously stated, (please see here), the Fed’s favoured inflation measure, the Core PCE reading, has averaged well below 2% since the 2008/9 global financial crisis and is currently just 1.1%).
Furthermore, the Fed has previously stated that increasing US interest rates was conditional on achieving maximum employment – and in our opinion, getting inflation to consistently run above 2% as well as achieving maximum employment is an extremely big ask within the next couple of years.
As such, US interest rates are unlikely to rise anytime soon – in fact, we wouldn’t be surprised if they remain at their current level of 0.25% for several years (and when they do eventually rise, the path is likely to be very slow and shallow). Furthermore, the Fed is also unlikely to withdraw their QE stimulus (i.e. bond buying program) – although we accept they may start talking about tapering it.
‘Tapering QE’ is akin to simply removing your foot from a car’s accelerator – i.e. tapering QE would mean that the Fed simply starts to buy slightly less bonds than they currently do. Tapering certainly doesn’t mean stopping QE (i.e. putting your foot firmly on the brake pedal), let alone reversing QE (i.e. selling the bonds the Fed have purchased).
Consequently, contrary to Jeremy Grantham’s expectations, we believe that the Fed will keep monetary policy exceptionally loose for the foreseeable future and that the current low interest rate environment is the new normal: interest rates aren’t going to ‘normalise’ at 5% or 10% – and this is very supportive for global equities.
Furthermore, lazy business journalists love to refer to high share prices as being an indicator that equities are in one massive bubble and have recently claimed that equity markets can’t keep ignoring disappointing economic data, such as last week’s US employment numbers.
However, Michel De Montaigne’s quote “nothing is so firmly believed as what we least know”, springs to mind!
With reference to last week’s US employment data, as we pointed out in our last Market Update (please see here), while the reading did disappointingly show that 140,000 jobs had been lost during December, the data for October & November’s job gains was revised up by a total of 135,000 – which meant the unemployment rate was unchanged at 6.7%. And we haven’t exactly been bombarded with disappointing economic data. In fact, most economic data has recently beaten expectations – for example, as we have previously highlighted, US ISM (Institute for Supply Management) data not only beat expectations, but more importantly indicated that the US recovery is actually accelerating.
In the UK, December’s PMI was revised up from an initial reading of 57.3 to 57.5 – its best reading since November 2013. And while we can’t deny that the FTSE-100 has recovered strongly (up around 35%) from those dark days last March when the index briefly dipped below 5,000, it is still around 1,000 points (12%) below its pre-coronavirus level.
And while it is easy to find companies that have seen dramatic share price rises and now trade on high equity valuation measures, for example a price-to-earnings ratio, such as Ocado in the UK or Tesla in America, their ascent can be understood and justifies.
For example, while the online food retailer, Ocado, may look expensive relative to UK food retailers such as Tesco, Sainsbury’s and Morrisons, Ocado is actually more of a technology company than a food retailer, having announced several technology licensing deals with supermarkets around the globe to operate their online delivery systems – i.e. fitting client warehouses with its propriety technology and robots, which reduces the capital intensity of food retail delivery. Likewise, Tesla isn’t simply a car manufacturer like Ford or Volkswagen, as it has a very different business model, with leading-edge technology and none of the costly baggage that traditional car manufacturers have, while Joe Biden’s infrastructure and clean energy plans could also hugely benefit the company.
As such, we don’t currently see any obvious catalyst for global equity markets to sell-off and there are certainly no signs of a bubble that is about to burst – in fact, we see plenty of upside potential for global equity markets, as we don’t believe the economic recovery has yet to be fully reflected in equity prices.
However, the path for equity markets is never smooth or easy and unfortunately we fully expect equity market volatility will remain elevated in the short-term given the tug of war between the roll-out of the coronavirus vaccine and further stimulus on one side and the rapid spread of the new strain, coupled with the possibility of stricter lockdown restrictions, on the other.
Investment Management Team