Risk assets performed well again in August. Chair Powell said nothing in his keynote speech at Jackson Hole last week to reverse the positive trend. Low real yields continue to underpin valuations in developed equity markets.
Powell at Jackson Hole
The highly anticipated speech from US Federal Reserve chair Jerome Powell at the Jackson Hole symposium on 27 August went down well with financial markets. Chair Powell achieved this by confirming that a taper is coming but disconnecting it from decisions on interest rate policy.
Here are what we see as the key points from chair Jerome Powell’s speech:
A tapering of asset purchases by the US Federal Reserve is on the way. The likely sequence is the following three-step shift:
- The meeting of the Federal Open Market Committee (FOMC) on 21-22 September could give rise to a change in the FOMC statement to say that the economy is ‘close to having made substantial further progress’. This, somewhat vague phrase, indicates the economic progress necessary towards meeting the Fed’s inflation (2% and forecast to stay above that level for some time) and employment (full employment) targets.
- Subsequently, assuming Covid does not temporarily derail the jobs recovery, a declaration would follow at the FOMC meeting on 2-3 November announcing that ‘substantial further progress has been achieved’
- From 1 December the rate of bond buying by the Federal Reserve would slow (currently purchases amount to around USD 80bn of US Treasuries and USD 40bn of mortgage-backed securities each month).
The key question about the taper then becomes: when will it finish? The market consensus is probably for it to end during the summer of 2022. The general tone of Powell’s speech was that he is in no rush to hike rates. In our view, this tilts risk toward a slightly more elongated taper process.
On inflation, Powell continues to argue that price pressures are concentrated in a narrow range of sectors, and that wage and inflation expectations are not worrying, all suggesting that the current spike in inflation will be ‘transitory’.
Chair Powell still sees strong demand for workers in the labour market. He expects robust payroll figures, but he stresses the jobs market has a long way to go before it can considered to be fully healed.
In recent weeks the financial media has been full of comments from hawkish FOMC members calling for hikes in 2022. Powell pushed back against that line of thinking noting that:
- Forward guidance on lift-off for monetary policy is a ‘substantially more stringent test’ than the criteria that needs to be met for the Fed to taper quantitative easing (QE).
- There is ‘much ground to cover’ to get back to full employment.
- It is not certain the US has returned to a world of 2% trend inflation. The implication is that the Fed chair sees a meaningful risk inflation will go back to the 1.75% rate seen during the pre-Covid-19 era once the used car/hotels/supply-chain price shock expires.
- Pre-emptive tightening of monetary policy in response to what turns out to be transitory inflation would entail a significant cost – it would reduce job growth and slow the economy unnecessarily.
More of the lower for longer
By giving investors reassurance that US policy rates will stay at zero, possibly for years to come, Chair Powell did nothing to impede the continued rise in US stocks. In August the S&P 500 rose 2.9%, its seventh consecutive monthly rise. It is now up 20.4% year-to-date in 2021 and has doubled in value since its Covid-era low on 23 March 2020. This year’s rally has also been remarkably smooth with no fall in the S&P 500’s level of 5% or more since October 2020.
So, what comes next for equities?
Our analysis is that although global economic growth likely peaked this Spring, the subsequent slowdown, which the Delta surge could aggravate in the third quarter, should not threaten the overall recovery. As economies re-open, there remains considerable scope for strong demand for goods, and consumption data for services should also show an acceleration.
Equity valuations have benefited from the consistently stronger-than-expected rise in earnings, which has continued unabated since the end of the first lockdown. The outlook for earnings from here remains favourable even if expectations for the upcoming quarter may be overly optimistic. This support from earnings is crucial and should enable equity markets to continue to rise despite high valuations for some indices. We do not see the impressive stock market performances since the trough in March 2020, or the numerous new records being set by equity indices, as destabilising factors in themselves.
Sustained high equity valuations implicitly assumes that any rise in long-term bond yields will remain limited and orderly. Central banks have so far managed to avoid a repeat of the ‘taper tantrum’ episode in the Spring of 2013, when yields of US bonds rose abruptly (see Exhibit 1 below).
The key driver of equity multiples is the discount rate and real yields. Currently real yields are low in both the US (see Exhibit 1) and Germany (see Exhibit 2). They have fallen over the course of the summer, but any sharp rise could provoke a swift de-rating of equity valuations.
For more on the outlook, read our asset allocation monthly for September- click here