While the global rollout of the COVID vaccines remains uneven, progress continues to be made and specific country models do exist to show the real benefits of the vaccines (charts below). While politicians may be engaged in endless blame games, investors’ confidence is increasing in the full reopening of global economic activity.
Why then is this ‘good news’ resulting in rising volatility in almost every global asset class?
We believe due to two main reasons.
The first reason is primarily related to specific US conditions, but as the largest financial market, actions there reverberate across the globe. As COVID-19 issues recede from the list of major investor concerns, their gaze is now turning to an economy that is well on its way to full recovery but is still receiving unprecedented levels of both fiscal and monetary stimulus. Jay Powell (US Fed President) and Janet Yellen (US Treasury Secretary) are speaking in unison of the need to act aggressively now to spur growth and of their belief that any resulting inflationary forces can be easily controlled in the distant future.
Investors are starting to doubt this assertion.
This doubt has increasingly been expressed through rising government bond yields. US bond yields have been rising since Q2 of last year and the chart below shows how global yields have followed despite vastly different domestic recovery expectations.
Consensus expectations for US GDP growth in 2021 are +6% (the last time the US grew this strongly Reagan was in power and the 10 year yield was >10%). There are already early signs of rising price pressures. Fiscal stimulus is about to get bigger. The only path for interest rates is higher. Much has been made of the steepening US yield curve which has now broken the 1.2% level. However, as the chart below shows, if this recovery is sustained, a more normal yield spread by historical standards should be north of 3%.
Very simply, there is a high probability that the US 10-year yield breaks 2% (global yields will also be dragged higher) and the consensus is nowhere close to this forecast.
Which brings us to the second reason for increased financial asset volatility. Interest rates have been ignored for so long in valuation models in a zero interest rate world. Interest rates are the gravity of financial valuation. Without their input, valuation becomes subservient to fanciful growth narratives and meaningless relative comparisons.
Just a week ago we came across a note from a Goldman Sachs analyst upgrading his price target on Palantir Technologies. His new target was based on the current valuations of other companies growing revenue at 30% (earnings and cash flow did not enter the discussion). The new target price was set at 44x 2021 estimated SALES (not a typo).
To put this into context, the NASDAQ 100 index, which contains a list of highly valued technology companies, ‘only’ sells for 5x sales. Valuing Amazon at that multiple would give it a value of over $20 trillion – just larger than the entire US economy.
There are large segments of the main equity indices that are not correctly priced for a normalised interest rate environment. The following chart of the relative performance of the main US Growth Index (which contains the highest valued stocks) shows that it has struggling during the last 6 months and looks to be rolling over. What has changed? Growth rates and earnings performance has remained strong. The key difference is interest rates.
The chart below looks at five of the Growth heavyweights (FAANG stocks). After a period of extended outperformance, it is also notable that the only member of this group which has managed to keep up with recent market performance is Alphabet.
The two charts below provide another perspective on the impact of zero interest rates on the investment performance of two sectors. Financial stocks have significantly underperformed since 2008 (note that this was the largest sector weighting in the S&P at that time). Low economic growth and interest rates have acted as strong headwinds for this sector stymieing earnings growth.
The mirror image has been the performance of the technology sector which has benefited from some secular growth trends but also from a significant valuation rerating. With interest rates on the rise, the case for a narrowing of the performance differential over the last 10 years is gaining credence.