Reflation trade pushes equities to new records

By Hussein Sayed, Chief Market Strategist at FXTM

Appetite for risk is not showing any signs of ebbing away. Asian stocks hovered near record highs in early Monday trade, with European and S&P 500 futures advancing further following a new record close for US indices on Friday. US 10-year Treasury yields also hit a post-pandemic high of 1.19%, while Brent Crude reached a new milestone of $60 per barrel.

Slowing coronavirus infections, continued rollout of vaccines, and anticipation of President Biden’s $1.9 trillion rescue package is keeping the bull market well and truly alive. Several risk sentiment indicators climbed to their highest levels since the pandemic stunned global economies and financial markets.

Contrarian investors may look at breakeven inflation rates and point to the risk of higher expected prices due to fiscal stimulus and monetary policies. Indeed, these rates, which are indicating 2.2% average inflation over the next 10 years, are a considerable risk and we may see them moving higher over the next several months. However, this risk will not materialise until further in the future as the Federal Reserve is unlikely to taper asset purchases before next year, while keeping interest rates at very low levels until early 2023.

Treasury secretary Janet Yellen boldly stated on Sunday that the US could see full employment by next year if Congress passed the proposed stimulus package. Assuming this is an unemployment rate of around 4.1% according to longer-run median projections by the Federal Reserve, that makes her estimate 0.9% below the Fed’s December projection. While she admits the size of the stimulus package risks overheating the economy, the main issue to tackle now is unemployment and the suffering of small businesses.

There is no doubt that valuations are becoming extremely overstretched, especially in the Tech sector. Wild moves in other risk assets such as crypto currencies are also an indication of excessive risk taking. I don’t know whether we are in a bubble territory yet, but we are certainly close to it. Having said that, I still expect to see further rallies in equities in the near future. The reason is that investors are willing to discount inflation risks well into the future, while monetary policymakers are continuing to be supportive. Another factor supporting higher equities is earnings. So far, 81% of S&P 500 companies reported a positive EPS surprise for the final quarter of 2020 and this could actually lead to positive earnings growth for the quarter compared to the fourth quarter of 2019.

Valuations will be a chapter to deal with later. Investors will need to closely monitor when monetary policymakers in the US and the rest of the world signal that they are turning the music down. That would be the time for exit. Until then, bulls are likely to continue enjoying the ride.