Markets are due a pause for breath

Shares continue to rocket, with equity market gains in 2020 impressive. But can this performance continue?

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  1. Garry White

After the party comes the hangover. The risk-on rally in equities that started at the end of September looks overdue for a pause – and any correction following the recent melt-up would be pretty healthy. For investors becoming concerned that they are missing out on market gains, now may not be a good time to be chasing the equity bull.

The US benchmark S&P 500 index continues to hit new highs. So far this year, the MSCI All Country index is up a solid 2.5%, adding to a gain of about 24% in 2019.

Equity markets rose last year at the highest rate since 2009, when global indices soared from the lows hit following the sell-off during the great financial crisis. With corporate earnings and economic data looking pretty soft right now – and valuations significantly more elevated than ten years ago – this year’s rally does not appear to be supported by fundamentals. 

Racy gains

Tellingly, much of the gains so far have been seen in more racy parts of the market. In 2020 so far, shares in Elon Musk’s Tesla have gained 22%, doubling over the last six months. Plant-based burger company Beyond Meat is also up a staggering 44% in just a fortnight – but neither of these companies are turning a profit and are unlikely to do so soon. They may have a good story to tell about market disruption, but it appears that FOMO – or the fear of missing out – is once more in the driving seat. This has resulted in a typical market melt-up. 

A melt-up is a dramatic improvement in performance, driven by a stampede of investors who don't want to miss out on its rise. Such moves are not good indicators of market direction over the medium term and need to be treated with a significant degree of caution.

A lot of this has been driven by the Federal Reserve which, under pressure from Donald Trump, has been equity market friendly. Its action taken since the crisis in the repo markets in September has acted as rocket fuel for equities, with a lot of these recent gains driven by extra liquidity. 

Federal Reserve boost

The repo market provides short term funding. Cash is borrowed for short periods backed by high-quality collateral such as Treasury bills. But the price of repo market financing soared in September, with the cost spiking to around 10pc at one point, prompting concerns that banks were running short of cash. This caused the Federal Reserve to intervene in the market, providing billions in liquidity to keep repo rates low.

At the time, the repo-rate spike was put down to a confluence of benign events. A tax deadline emptied money from corporate bank accounts and an auction of Treasury bills also caused a spike in demand for cash. But the US central bank is still injecting liquidity and looks likely to until April. The Fed has said it will start to cut back its interventions next month, but only modestly. Once these liquidity taps are turned off – as they ultimately will be – then it is likely there will be some form of pullback in stock markets.

The so-called ‘Trump put’ is also dead. Over the last year or so, each time the market fell he tweeted some positive news on discussions with China on the trade deal to reverse its course. This will no longer work. In fact, newsflow could be negative as this agreement is pretty easy for both sides to break. It can be terminated in 60 days by either party unilaterally renouncing it in writing. The targets set in the document are also likely to be hard to be meet, so there could be problems with compliance before long too. There is significant potential for negative trade news in the coming months.

Earnings reality

US corporate earnings season appears to have got off to a good start with the investment banks – but this sector, alongside utilities, was expected to show the biggest earnings growth of all. So, we now have companies in some of the more disappointing sectors to come. Energy is expected to fare worst, with sector earnings down by more than 35%. Consumer discretionary, materials and industrials are also expected to see a substantial contraction in earnings and expectations for profit growth this year appear on the high side, broadly speaking.   

Recent gains are arguably a liquidity rally caused by the Federal Reserve, which is under pressure from Donald Trump to keep equity gains going ahead of the presidential election in November. They have disconnected from the real fundamentals of the market. The real danger, particularly for private investors, is that the fear of missing out will tempt them back into the market at a time when equities are trading at nosebleed valuations. 

Of course, should Federal Reserve Chair Jerome Powell continue to act as Mr Trump’s electoral wingman and inflate an equity bubble, with no external shocks to bring valuation back to more realistic levels, this rally could continue for some time. But equity inflows are suggesting a solid rebound in global manufacturing, which has not yet been seen, and a substantial pick-up in corporate earnings, which is unlikely anytime soon. Eventually, markets should revert to reflect the real economic fundamentals. The higher this liquidity bubble is blown, the harder it will fall. 

A version of this article appeared in Friday’s Daily Telegraph.

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