We are at a counterintuitive stage of the recovery from the COVID-19 pandemic as markets sell off on the prospects of faster-than-anticipated economic growth. However, if you look closer, you can see that the selling is a little more discriminate than that; those companies with better long-term growth prospects are taking the brunt of the selling.
What is going on? Well, the best way to explain it is to refer to recent history. Sadly, the recession caused by the pandemic is the second financial crisis investors have experienced in the last thirteen years and the tools used to navigate our way out of the GFC have been used once again in 2020 but much sooner and on a far larger scale. In 2013, as global economic prospects started improving, the US Federal Reserve announced that it would begin to wind down its quantitative easing program. We then saw what is now referred to as the taper tantrum, with bond markets selling off aggressively and taking equities with it. The fear in 2013 was that the economy was too reliant on monetary support to continue the recovery in its absence, and bond investors were unwilling to buy bonds without the Fed in the market buying as well. This time the fear is surging inflation, but the impact on long-term bond yields has been similar.
It is essential to understand why higher interest rates can lower valuations on equities (and other risk assets such as property). Interest rates, or the risk-free rate, are the opportunity cost in investing in risk assets such as equities or property. The higher the risk-free rate, the higher the return needed from equities to warrant the risk taken in investing. And that risk-free rate is used in modelling the present-day value of future cash flows in that future cash flows are discounted to today’s value (with the future interest rate equating to the discount rate).
So, are we looking at a correction or even the beginning of a bear market? While it’s certainly possible, there is plenty of evidence to suggest otherwise. Logically, a healthier economic outlook will translate to faster growth for global companies, so even an earnings multiple (price divided by earnings, or PE) contraction might be more than offset by a higher earnings number. And if history is any guide (i.e. 2013’s taper tantrum), we saw just that and, with inflation never rising to central banks’ target ranges, interest rates remained subdued. We have heard commentary from many central bankers lately that inflation is just not a concern and that many of the inflationary pressures we are seeing (such as surging oil and copper prices) are a direct result of government stimulus. Therefore once that tap turns off, they are more concerned about demand holding up than sustained excess inflation. It’s important to note that while 10-year government bonds have doubled since successful vaccine trials were announced, they are still below where they were before the pandemic hit, and interest rates have been trending down for some time because inflation just hasn’t sustained.
