Risk aversion returned across global equity markets with US IT stocks (+29% YtD vs S&P500: +6%) taking the biggest hit
Global equities took a breather in the past week. With equity valuations running well ahead of fundamentals (EPS) due to, inter alia, abundant liquidity by central banks and ultra low real interest rates, investors embarked on some profit taking, especially in the Information Technology (IT) sector which has demonstrated a stellar performance overall in 2020 with (its) valuations at very elevated levels. Option-related selling (the put/call ratio reached an historical low before the sell-off) probably amplified the correction. In the event, the MSCI ACWI was down by 2.3% wow (+1.4% ytd), with IT stocks decreasing by 3.6% wow (+25.2%). In the US, the S&P500 declined by 2.3% wow (+6.1% ytd), with the heavyweight IT sector down by 4.2% wow (+28.8% ytd).
Regarding fundamentals, recall that the 12-month forward P/E ratio (share prices divided by consensus estimates for the 12-month forward earnings per share) stands at 20x for the MSCI ACWI versus a 15-year average of 14x. In the US, the respective ratio for the S&P500 stands at 23x versus a 15-year average of 15x, with the IT sector reaching 29x intra-week before correcting slightly (15-year average of 16x | see graph). The elevated P/E ratios are also based on an optimistic consensus view for the 12-month forward corporate profitability, thus an elevated denominator, which limits an otherwise even higher P/E ratio. In the event, consensus expectations for the S&P500 suggest a strong and sustained “V”-shaped recovery for corporate profitability, with the annual growth bottoming out from a trough of -32% yoy in Q2:20 to -22% yoy in Q3:20, -13% yoy in Q4:20, +14% yoy in Q1:21 and +44% yoy in Q2:22. Positive vaccine/therapy news are important to support the (i) ongoing economic recovery and (ii) elevated equity valuations.
Looking forward, the main catalysts that fueled the equity market rally in recent months, i.e.: i) low interest rates and balance sheet policies by central banks; ii) large size fiscal stimuli; iii) stabilization of epidemiological data and optimism for positive developments in the medical field against Covid-19 and; iv) positive surprises regarding corporate results and economic data (see graph at page 3), largely remain in place, albeit with weaker expectations for an imminent new massive US fiscal stimulus.
In the event, negotiations in the US legislature appear to have stalled, with the current standpoints regarding the size of proposed packages, reportedly at $1.1 tn (5.2% of US GDP) from the Republicans (versus an initial proposal of $1.0 tn) and at $2.2 tn (10.4% of US GDP) from the Democrats ($3.4 tn initially). In that context and given also that an agreement on large size spending bills just a very short time before the Presidential elections (in November) is politically challenging, the possibility has risen for relatively smaller spending bills to be agreed at the current juncture (also to ensure the funding of the federal government after the end of September when the current fiscal year concludes), leaving the door open for more stimulus after the November elections.
It should also be noted that US fiscal dynamics pose considerable challenges on the potential size of a new stimulus package. In the event, the Congressional Budget Office (CBO) estimates that the federal government deficit will come out at 16% of GDP in fiscal year 2020 (i.e. from October 2019 to September 2020), the largest since 1945, followed by also extraordinary deficits of 8.6% and 6.1% in fiscal years 2021 and 2022, respectively (taking into account only the already legislated measures). As a result, according to the CBO, the federal debt will reach a record 106% of GDP by fiscal year 2022. At the general government level (thus including the debt of state and local governments), debt will reach 143% of GDP in 2022 according to the International Monetary Fund (2020 Article IV Consultation, August 2020).
Attention also turns to the European Central Bank. With no monetary policy decisions expected at its meeting on September 10th, the focus turns to the press conference and the quarterly ECB staff economic projections, for a better insight as to how the stronger euro (see graph page 3), the recent changes in the US Federal Reserve’s policy framework (which also contributed to the recent strengthening of the euro against the US Dollar) and the latest economic data have affected monetary policy intentions.