Near- term market sentiment: Despite continued sabre rattling by North Korea and the predictably bellicose responses from President Trump, key U.S stock market indices such as the S&P500, the Dow Jones Industrial Average, and the NASAQ are at all-time highs. It is not just Wall Street that is all-forgiving at present, so far this month we have seen a gain of 1.5% for the MSCI World index of developed stock markets, as measured in local currencies (and up 1.9% up in U.S dollars), with gains shared by most regions. Optimism is supported by respectable GDP growth in all the major economies, and expectations of continuing low U.S and global interest rates. Numerous polls of professional multi-asset fund managers suggest a strong pro-equity bias at present. This confidence is echoed by expectations of low stock market volatility: the VIX index (the so-called ‘fear gauge’) stands at just 10.1, indicating that investors expect the S&P500 index to be not too far from today’s value in a month’s time.
Can stock market gains persist? Yes, so long as the risk-free rate remains low. By which we mean, so long as bank account cash rates and core government bond yields continue to offer dismal returns to investors, forcing cash in more rewarding stock markets.
On this score we are re-assured by central banks’ caution over raising interest rates against a back ground of generally weak inflation throughout the developed world.
This week’s Fed meeting is unlikely see its policy makers alter their existing forecast of 3% interest rates end of 2019. This is more than twice the current level, but given the tendency in recent years for the policy members to over-estimate future interest rate levels, the actual peak in the current rate cycle is likely to be lower. A very gradual approach to rate hikes is coupled to promises of a very slow unwinding by the central bank of its enormous bond holdings. All of which limit the risk of U.S monetary policy tightening too fast, and so undermining American and global bond markets.
Given the surprising persistence of CPI inflation in the U.K, a rate rise before Christmas looks a possibility. But with all of the uncertainties of Brexit, anything more than one 25pb rate hike over the coming 12 months seems unlikely.
The ECB is not about to rock the boat either. For all Mario Draghi’s bluster about seeking to tapper the ECB’s asset program, he and his policy-making colleagues are hamstrung by the knowledge that some southern European bond markets might collapse if the central bank ceased buying their paper in current quantities. This would result in a renewed round of fiscal austerity on those countries, and -in all likelihood- stretch those countries’ baking systems to the limit, as their holdings of domestic government bonds fall in value. The ECB governing council is unlikely to risk such a scenario, and will persist with its current EUR 60bn a month bond purchases.
Therefore, as I wrote a few weeks ago, the returns from cash and core bond markets are unlikely to improve over the coming year at least. This supports assets that can produce a yield, and that will respond positively to rising GDP growth, such as equities. But some asset classes do appear overvalued in relation to their risk, not just Argentinian 100 year bonds but parts of the U.S high yield market and possibly also the leading quoted U.S tech stocks. In view of the low risk-free returns available, any correction in these markets is unlikely to trigger an across-the-board sell-off of global stock markets or investment grade bonds, but merely see the proceeds of sales re-invested in lower risk (but still yield-producing) stocks and bonds.