The second concern is the scale and speed of a pullback in monetary and fiscal policy support. In There’s been much discussion on monetary contraction around when tapering will start, but we think this misses a key point. The real change in absolute levels is what really matters. Globally, the positive impact of central bank asset purchases has already peaked and will be modest by the start of 2022 Q1. Though global tapering might not happen till Q4 2022, the positive impact of purchases stops by end Q1.
The European Central Bank (ECB) has announced a relatively dovish “taper” of its asset purchases for the fourth quarter of this year. Furthermore, the eurozone bond market has started to consider the prospects of ECB rate increases. The latest, relatively subdued ECB inflation forecasts, combined with the new rates guidance still – we think – mean the prospect of a lift-off in policy rates is some way off. This probably means that the eurozone rates sell-off (German 10-year yields have risen to -0.33% from a low of -0.54% in mid-August) has been overdone.
Policy purse-strings may tighten
Turning to fiscal spending, though post global financial crisis (GFC) austerity discussions may feel like a lifetime ago, they’re likely to return to focus. The potential contraction in Government spending is currently forecast at -2.5% of global GDP in 2022, compared to a positive stimulus of 4% of GDP in 2020. This is assuming that governments stick to current plans and that Covid relief measures are not extended. But if it does materialise, this will be a tightening of policy five times larger than that seen after the GFC.
In Germany, the upcoming general election will bring this ‘expansion versus austerity’ debate into sharper focus. The expected winners are likely to have a more fiscally liberal approach which could include abandoning the Black Zero approach (one which doesn’t tolerate government budget deficits). But there’s no unified global approach to tackling the deterioration in government finances. The UK, where taxes will be increased to fund social care, suggests a different direction.
And in the US, there’s much more fiscal stimulus in the pipeline – around US$4.5tn (the US$1tn infrastructure package and the US$3.5tn American Families Plan). At over 20% of US GDP, this would be a record level of stimulus. To be passed, it will require a simple Senate majority, following a process of reconciliation. It could be too much for more conservative senators to accept. Democrat senator Joe Manchin of West Virginia publicly stated that the US$3.5tn package is too big and he cannot support it. The package will likely need to be reduced and may take longer to pass, especially given the more urgent issue of dealing with the debt ceiling. The US Treasury could well run out of money by November, raising the spectre of a US debt default once again.
The China conundrum
It’s also worth noting developments in China. A bailout of Evergrande’s bond holders (largest property developer in China) seems unlikely as its loans seem sufficiently collateralised, reducing the risk of contagion. But once again, the company’s problems have focused concerns on the continuing clampdown by the state on some of the capitalist elements of the economy. This has concerned many foreign participants in Chinese financial markets enough to cause large outflows. The result is that valuations look attractive relative to other equity markets but like a post Brexit UK, the debate is whether these valuation levels will remain low relative to other markets.
Financial markets have been surprised by the world’s resilience to Covid-19 and the outlook for growth, revenues and earnings look good. This is a relatively consensual view though – and that appears to be well priced into market valuations. Trailing and forward price-to-earnings (P/E), enterprise value-to-EBIT and operating cash flow are all well into the 90th percentile. The cyclically adjusted P/E at 26.2x is well outside its historical 10-20x range and easily the highest outside of the tech bubble.
We’re therefore vigilant in looking for catalysts that could hinder markets. Post-covid margin pressure and falling monetary and fiscal stimulus are top of that list at present. These raise the spectre of a short-term pull back in equities; but the ‘TINA’ phenomena remains a valid and potentially powerful force for equities. It is well illustrated by MSCI European equities having a 3% dividend yield compared with -2% for 10-year real bund yields. This is close to a record high spread at circa 500bps – so we’re bullish long-term but in the short-term, wary.
