Negative real rates drive valuations of multiple asset classes
August 10, 2020
Equity markets are set to begin the week similarly to how they ended last week, with the S&P 500 IndexTM aiming to gain for the sixth gain in seven weeks. The S&P 500 is within 1% of the all-time high despite continued uncertainty over coronavirus and a recent inflection in the pace of the economic recovery.
The decoupling of the performance of equity markets and the economy continues to confound investors, but recently, the decoupling of other market performance is equally confusing. Equity markets exude optimism, while near-record-low bond yields are consistent with slow growth and record gold prices would be consistent with inflation. A potential explanation of why asset classes are acting different than their historical patterns is that real interest rates (adjusted for inflation) are negative across the curve. The “opportunity cost” (i.e. lost income) of investing outside of fixed income has faded, shifting the valuation investors are willing to pay for other asset classes. We get two readings (PPI & CPI) on inflation this week, though the backward-looking nature suggests markets may not react as they are instead focused on the inflation rate derived from the bond market.
President Trump signed executive orders on coronavirus stimulus as Republicans and Democrats failed to come to an agreement. Given the limited scope of the deal and the positive market reaction, equity investors continue to embed a likelihood that a larger agreement is reached. Comments by President Trump on Monday suggest that likely as well.
Second-quarter earnings season is largely over, with a record-setting percentage of beats (83%) and degree of beats (22%) relative to estimates. Expectations are rising for the third and fourth quarter, but most of investor focus is on the trajectory of the 2021 estimate, which has inflected higher. The S&P 500 is 30x the current 2021 estimate, suggesting that investors are expecting further upward estimate revisions.
Democrats and Republicans were unable to bridge the gap and come to an agreement on the fifth phase of coronavirus relief, causing President Trump to act unilaterally with a combination of memorandums and executive orders. Included is the authorization of states to offer $400 per week in additional unemployment benefits (75% from federal government), the deferral of the 6.2% Social Security tax on those making less than $100k a year and allowed a furlough of student loan payments and interest through the end of the year. He did not reauthorize the federal eviction moratorium but called on the DHS and CDC to “consider” if such a move was necessary. The actions do not preclude Congress agreeing on a new phase of stimulus.
The extraordinary performance of a few large technology companies has some worried about the market’s concentration. The 10 largest companies in the S&P 500 now account for 29% of the index, the largest level in at least 40 years and up from 23% at the end of 2019. Many of these are in the NASDAQ, which is at a record high, gaining 23% this year, and trading at 33x forward earnings (highest since just after the technology bubble). While the concentration makes the market susceptible to a hiccup in the technology sector, this group showed the most strength in the recent earnings reports and has some margin of safety with strong balance sheets and cash flow generation.
Earnings season is largely over, with 90% of the S&P 500 reporting. While earnings fell 34%, we saw a record in the percentage of beats (83%) and the degree of beat (22%), reflecting the conservatism embedded in the Street’s estimates. On average, multinationals, growth and quality beat more than domestic, value and momentum. Analysts predict declines in 3Q (-23%) and 4Q (-13%) before a return to growth in 1Q21 (+13). The estimate for 2021 continues to rise, with the current estimate of $166, implying 26% growth, though the S&P 500 is still expensive on that metric (20x), placing increased importance on beating that number.
What to Watch
Inflation data will highlight this week’s releases, with PPI on Tuesday and CPI on Wednesday. Other data points include retail sales, industrial production and consumer sentiment, all scheduled to be announced on Friday.
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