Time may be right for ‘temporary correction’

In the current recovery, the Fed is promising to keep rates pinned at zero and quantitative easing measures in place until after they reach their dual mandate objective. Picture: AFP

Markets may be in need of some reassurance that US interest rates will remain under control amid an expected ramp-up in US fiscal stimulus under president-elect Joe Biden.

That should come with the next Federal Reserve meeting, or sooner if US financial conditions tighten significantly, the COVID-19 pandemic worsens and the vaccine rollout in the US is frustratingly slow.

So far the jump in bond yields and minor slippage in the US sharemarket has had no meaningful impact on US financial conditions, after the Bloomberg gauge hit a 10-month high last week.

Hence, some strategists say the time may be right for a “temporary correction” in the S&P 500.

A tense US political situation amid pressure to impeach Donald Trump over last week’s insurrection at the Capitol, and the FBI’s warning of plans for nationwide armed protests before next week’s inauguration can be added to the list of concerns for risk assets which in some cases experienced massive gains following the vaccine breakthroughs and the US election outcome last year.

Australia’s sharemarket retreated for a second day on Tuesday, with the S&P/ASX 200 index closing down 0.3 per cent at a three-day low of 6679.1, after surging 2.9 per cent to an 11-month high last week.

But while it’s hard to imagine Joe Biden tweeting as much about the stockmarket as Donald Trump did, major fiscal stimulus is a top priority, and bond yields will be restrained by an accommodative stance and potentially even greater quantitative easing from the Federal Reserve, at least until COVID-19 is under control and inflation averages above the 2 per cent target for some time.

US equity strategists have been increasingly cautious this year, albeit none predict a major fall. Canaccord Genuity’s Tony Dwyer, says his key tactical indicators point to a “temporary correction” that would “set the stage for the next sustainable move higher” on the back of his core fundamental thesis, driven by historic liquidity fuelling a synchronised global economic recovery.

“While corrections only feel ‘natural, normal and healthy’ — until you are in one, it is essential to remember if it unfolds — the three levels of stimulus are likely in place through 2021, the political uncertainty appears to be clearing, and we can see the light at the end of the tunnel for a global economic reopening as vaccinations accelerate,” Mr Dwyer said.

“The S&P 500 valuations are near ‘dotcom’ levels, equity offerings are historically high and ramping, and information technology has been the leader, but there are some very important differences,” he said. “In 2000, the real Fed funds’ rate was historically high, corporate credit was dislocating, and financial conditions were tightening … historically high valuations were on peak earnings as the economic cycle was ending, whereas in 2021 we are coming off trough EPS.

“In our view, the market valuation expansion is more like what took place following the 2009 low.”

In the current recovery, the Fed is promising to keep rates pinned at zero and quantitative easing measures in place until after they reach their dual mandate objective.

Inflation remains well below the Fed target, so monetary policy shouldn’t tighten for the foreseeable future, and low core inflation in the face of an increasing 10-year inflation break-even rate allows the Fed to keep its zero-interest-rate policy and similar levels of asset buying through 2021.

“While many worry the historic excess liquidity could generate inflation, especially given the move higher in market-based inflation gauges, both the Core PCE and long-term inflation expectations have not altered Fed policy,” Mr Dwyer said.

While the recent rise in the 10-year US Treasury yield has created fear of tighter financial conditions, he notes that corporate debt yields are at or near record lows despite the historic supply, money supply growth keeps reaching record levels, and the Chicago Fed net financial conditions sub indexes are trending lower despite higher US Treasury rates.

“The excess liquidity fuelling the global recovery has come from three stimulus programs that have warranted an above-consensus view of earnings per share for 2021, even if president-elect Biden pushes through his 28 per cent corporate tax hike proposal in the US for this year,” he said.

The Fed is now buying $US120bn ($155bn) a month of assets and some Fed presidents have indicated more monetary stimulus may be needed to get to their average of 2 per cent target.

After the $US2.2 trillion CARES act was followed by the recently approved additional $US900bn COVID-19 relief package, Democratic Senate wins in Georgia have raised hopes of much more stimulus, with Joe Biden due to outline a plan for “trillions of dollars” on Thursday.

Mr Dwyer also said US companies should be able to save 20 per cent of their current coupon interest expense, or roughly $US73bn in total.

“We believe a 20 per cent drop in corporate debt interest expense would translate to a 4.3 per cent increase in the 2021 consensus estimate of $168 per share,” he said.

“As a result, we believe our $176 per share EPS estimate may prove conservative. We do not expect a corporate tax hike due to elevated economic risk from the pandemic in 2021, but if one is passed, the impact of the lower interest expense should more than offset the higher tax rates.”