The coronavirus pandemic that swept the world a year ago hijacked the global economic cycle. Happily, for investors, we’re now in the “Goldilocks” phase of recovery, when consumer demand is no longer too cold nor inflation yet too hot to restrain growth.
Whether the world economy is indeed out of the woods depends at least in part on the progress of COVID-19 and how people respond to it. How well will vaccines work, including against new variants of the virus? Will enough people take them? And when will we all be vaccinated? While the developed world foresees full inoculation this year, it may take years for emerging economies to reach that point.
Regardless, the markets—always forward-looking—have moved on. Investors are basking in the glow of combined monetary and fiscal stimulus from governments and central banks while economic activity returns to pre-pandemic levels. The U.S. Federal Reserve has indicated it won’t be raising interest rates until at least 2024 and new U.S. government spending under the Biden administration equates to one-quarter of gross domestic product. Topping investors’ list of worries is not COVID-19 but instead the right-tail risk of this cycle: inflation and rising interest rates.
As Nicola Wealth president David Sung has pointed out, investors are feeling perhaps too confident, with the percentage of their portfolios allocated to equities approaching 100 percent. They risk falling into the wealth-destroying habit of buying high and selling low. “The greed and fear index is off the meter on the greed side,” Sung said.
CIO Rob Edel has echoed that theme. “Markets are factoring more than a full recovery,” he said. Is that stance over-optimistic? While the Case Shiller price-to-earnings ratio for the U.S. stock market is 88 percent above its long-term average—the only time it was higher was during the technology bubble in 1999 and early 2000—the fact that treasury yields have not yet recovered to pre-pandemic levels suggests valuations may in fact be appropriate.
The earnings yield on the Standard & Poor’s 500 index is currently 180 basis points higher than 10-year Treasury yields; the historical average spread is 63 basis points. “The market versus bond yields is not that expensive,” Edel said. “It’s actually quite cheap.”
Of course, bond yields, tracking inflation, are on the rise, but that doesn’t necessarily spell doom for the market either. As long as they are accompanied by economic growth, periods of moderate yield growth have historically been favourable for stocks.
Some market watchers compare today’s market conditions with the unsustainable technology boom at the turn of the millennium. Edel rejects that analogy. It’s a misconception that the dot-com bubble was burst by rising 10-year treasury yields, he said. “It wasn’t bond yields that was the trigger, it was [falling] earnings yields.” So investors would do well to watch corporate earnings; right now they are rising fast—indeed, beating expectations. Another sign of danger to watch out for would be treasury yields surpassing 2.5 percent, meaning a 100-basis-point rise, over the coming year.
Eventually, of course, the market will turn, due to a drop-off in profits, a jump in inflation, something else or a combination of multiple factors. Read more on the prospects for rising inflation—which Nicola strategists think is likely—and what asset classes might fare best in this new reality in Part 2 of our Strategic Outlook Market Commentary, coming soon.
Watch the full 2021 Strategic Outlook event on April 28 here.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions.