Following a strong first quarter for equity investors worldwide, the second quarter is off to a good start as well, with most global stock markets already up by a few percentage points. While the sense that stock markets are potentially getting ahead of themselves is nothing new, the renewed surge of large-cap US tech stocks is.
Since the emergence of effective vaccines last autumn, the stock market darlings of 2020 had become laggards, as investors turned their attention to companies capable of benefitting from a pandemic in retreat and our collective desire to make up for lost time. But beyond this cyclical recovery theme, there was also the observation that the rising yields which accompany expectations of better times ahead would also prove a headwind for businesses whose expected substantial growth in earnings lay further in the future. We wrote about this ‘discounted cash flow’ dynamic before, but it was not entirely clear whether rising yields or expected changes in consumer post-pandemic behaviours were the more decisive determinant for the relative valuations of growth/tech companies.
The tech sector’s resurgence has provided more clarity, given it has coincided with falling yields but also growing threats to long-term earnings growth. This threat has stemmed from increasing government talk of raising corporate taxation to fund fiscal stimulus. After initially merely stabilising from their previous upward momentum, long-term government bond yields have declined slightly over the past week. This followed assurances from the US Federal Reserve (Fed) that it firmly expects recovery-driven price rises to be transitory, and should not result in structural inflation pressures to necessitate monetary tightening in the near future. So, we can reasonably expect that the growth/tech section of the stock market will face more headwinds when yields resume their gradual upward trend – in line with the expected upward trend of broader economic activity levels. Interestingly, that is how the more conservative utility stocks (often held as alternatives to corporate bonds) used to behave. Perhaps this is a sign for things to come. The growth stocks of the past decades have become so big they can hardly be expected to continue to grow at the same rate as in the past, while at the same time adopting more and more of the subscription-type business propositions that defines utility companies.
This is not the only interesting insight that bond markets provided us with this week. The chart below has even more forecasting value, in that it tells us something about capital market expectations as a whole, rather than for just one segment. It shows the development of government bond yields (orange line) and corporate bond yields (blue line) since the beginning of the year. Due to the higher default risk of companies over governments, corporates always pay a risk premium over the yields of the government, which is why have plotted corporate yields against a separate axis on the right hand side, to bring the two graphs closer together to permit better comparability.
The direction of travel of long-term government yields tells us something about the collective market expectations for the wider economy. If yields rise, it signals an expectation of better times ahead, in which bond investors demand to participate. If corporate bond yields fall at the same time, it tells us that market participants are growing less concerned about the risk that companies may fail. Now, that may not be overly surprising if the economic outlook is improving, but if the outlook improves so fast that it raises concerns of overheating, the risk premium actually increases. It suggests central banks may be forced to tighten conditions by raising rates, which often leads to credit default cycles as overextended companies fold despite booming economic conditions.
Both of these expectation settings are visible in the chart. We can first see the overheating scenario in February and early March, when rising corporate bond yields outpaced those of government bonds and, since then, falling costs of finance for corporates while government yields have traded sideways. This latest development is good news for the near-term outlook for investors with the majority of their portfolios invested in global stock markets. It indicates a market expectation of a ‘Goldilocks’ environment for the economy, of just the right balance between growth and the ability of companies to cope with the inevitable gradual rise in yields, as the rise in earnings is expected to outpace the rising cost of finance. This latest development may well be more driven by recent US policy initiatives, rather than the previous ‘end-of-pandemic’ driver of sentiment. The Biden administration has thus far proven to be even faster off the pace and relentlessly competent in steering the US economy towards a sustained recovery than many (us included) had dared to expect after the chaotic Trump years.
The chart below shows how equity markets have taken heart compared to one year ago. Back then, equity investors were rushing to insure their holdings by buying options. This led to the price of those options (as indicated by the CBOE Volatility Index) was above 60%, almost back at the level seen during the global financial crash 12 years earlier. By comparison, the index traded at just below 17% yesterday, almost exactly at the median level for the last 15 years. This does not tell us that there are no risks at present, but it does tell us that investors think that these known risks are no reason to panic.
The combination of fast progress on mass vaccinations – and real long-term structural improvement plans for the US economy – have provided investors with a very welcome perspective for sustained growth beyond the initial post-pandemic recovery phase.