A second wave of the “Great Rotation” was disrupted by the cautious commentary of the US Federal Reserve Board chairman, Jerome Powell.
Over the past month or so, as the “reflation” trade gathered momentum, the tech stocks and those companies that benefited from the pandemic began losing ground while the banks and manufacturers that had been most adversely affected saw their share prices rise.
It was a reprise of a short-lived rotation late last year, away from tech and defensive stocks towards cyclicals – companies leveraged to economic growth - that petered out around the end of last year.
That trend re-emerged late last month and then accelerated last week with the big tech companies – the so-called “FAANG” stocks of Facebook, Apple, Google’s parent Alphabet and Netflix – shedding 4.2 per cent of their value.
The overall market was down about one per cent over that same period, but that could be attributed to the 28 per cent of the US market’s capitalisation now exposed to those big tech companies. The rest of the market was up modestly.
The big tech companies, which trade on an aggregate price-earnings ratio of nearly 60 times, are extremely sensitive to interest rate movements because they are priced for continuing big increases in their future cash flows and earnings. A relatively small change in the discount rate used to establish a net present value for those cash flows and earnings has a leveraged impact on their valuations.
In recent weeks there has been a significant change in the US 10-year bond rate – the “risk-free” rate used in valuation calculations. It has risen from 0.90 per cent at the start of the year to 1.36 per cent, with most of that rise – about 24 basis points of it – occurring in the past fortnight.
As discussed previously, that rise in rates and a sudden steeping in bond yield curves around the world, including here in Australia, is due to optimism about the outlook for economies now that vaccination programs are rolling out and, in the US, another $US1.9 trillion ($2.4 trillion) pandemic relief/stimulus package looms.
The markets have been starting to price in an expectation of a rekindling of inflation to levels not seen since the 2008 financial crisis, which would force the Fed to raise interest rates and wind down its $US120 billion bond purchasing program.
Powell hosed down those expectations.
In testimony to the US Senate’s banking committee the Fed chair said the US economy was a long way from its employment and inflation goals and it would take some time for substantial progress to be achieved.
Even if Powell is wrong, it will take some time – several years, if the pricing signals in the bond market are accurate – before rates actually start to rise and properly stress test the some of the more stretched asset prices in financial and property markets.
The Fed would, therefore, continue to support the economy with its current policy settings of rates close to zero and its bond purchases.
While the inflation rate might be somewhat volatile over the next year as the economy strengthened that, he said, would be a good problem to have when for a quarter of a century or more all the pressures had been disinflationary.
He also said inflation dynamics do change over time but generally didn’t “change on a dime” and attributed the recent rise in bond yields to economic optimism rather than concerns about rising inflation.
Even if Jerome Powell is wrong, it could take years before rates actually start to rise and properly stress test the some of the more stretched asset prices in financial and property markets.Credit:AP
While there has been a lot of discussion around markets about the potential for rising interest rates to puncture a number of perceived “bubbles” in financial markets – bonds, equities (particularly tech stocks) and cryptocurrencies are the most obvious – Powell wasn’t concerned even though the Fed’s semi-annual report last week noted that US business leverage was near historical highs and the risks to financial stability were notable.
There was certainly a link between the Fed’s easy money policies and elevated asset prices, Powell said.
“I would say, though, that if you look at what market are looking at, it’s a re-opening economy with vaccination, it’s fiscal stimulus, it’s highly accommodative monetary policy, it’s savings accumulated on people’s balance sheets, it’s expectations of much higher corporate profits. So there are many factors that are contributing.”
Those comments beg the question, of course, of why stockmarkets were hitting record levels before there were successful vaccines and while the impact of the pandemic, particularly in the US, was intensifying.
Investors might embrace good economic news and use it to rationalise further gains in stock prices but the post-2008 loose monetary policies pursued by the major central banks have de-linked financial markets from their real economies.
During the pandemic markets have been underwritten by the central bankers’ responses. They’ve been fuelled by zero to negative interest rates, torrents of liquidity and a conviction, based on past performance, that the Fed and its counterparts elsewhere will bail them out if anything were to go wrong.
The more inflated asset prices become the more that conviction is buttressed by the threat to financial systems and economies if those prices were to deflate abruptly.
The wildcard is the inflation rate, which could force the Fed’s hand if it were to break out of the dead zone it’s inhabited this century, which is why the recent surge – albeit to still very low levels – in interest rates has caused such a buzz in markets.
It’s isn’t so much the absolute level of the rates as the speed at which they have moved and caused the yield curve to suddenly steepen despite the continuing heavy interventions of the central banks – in Australia the yield on 10-year bonds has almost doubled since October - that has unsettled investors.
Powell may be right and perhaps it is only optimism about the course of the pandemic and the strength of the economic rebound to come that is shifting the mood in markets, lifting bond yields and driving the switch in equity markets towards those companies that will most benefit from an end to the pandemic and a surge in economic activity.
Even if he is wrong, it will take some time – several years, if the pricing signals in the bond market are accurate – before rates actually start to rise and properly stress test the some of the more stretched asset prices in financial and property markets.
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Stephen is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.