Risk assets continue their February rally due to the prospect of a substantial US fiscal stimulus package and stronger-than-expected corporate results
US equities closed higher for a sixth straight session due to strong corporate results and upwardly revised expectations vis-à-vis fiscal spending. The S&P500 and Nasdaq-100 hit fresh all-time highs on Monday with valuations gains of circa 6% in February.
Procyclical sectors (Energy, Banks) and asset classes as small caps (Russell 2K) have led the increase. Region-wise, equity markets with high leverage on the global economic cycle overperformed, with Japanese equities reaching their highest level since 1990.
Big-Tech earnings surprised on the upside, with Google ($22.30 vs. $15.79) and Facebook ($3.88 vs. $1.25) beating analysts’ expectations by a wide margin. With 63% of the companies in the S&P500 reporting actual results, 81% have reported a positive EPS surprise, with positive year-over-year growth in Q4:2020 EPS of +2% compared with expectations of -9% at the beginning of the season.
The fiscal stimulus pushed by the new US Government, with Treasury Secretary Yellen calling for $1.9trillion or 9% of 2019 US GDP, has triggered a fresh debate on inflation. As a result, 10-year inflation breakeven interest rates have climbed by 47 bps to 2.21% since US Elections, their highest level since August 2014. In a similar vein, the options-implied densities assign considerably more mass (60%) to inflation outcomes above 2% compared with one year before (40%).
The inflation recovery could accelerate in the US, as fiscally fueled growth narrows the output gap, currently at -3.8% of potential GDP. According to the Congressional Budget Office estimates, real GDP is projected to surpass its potential level in Q1:2025 under current law. However, a multi-trillion package in 2021 would lift real output significantly suggesting that price risks are skewed to the upside.
In addition, survey and hard inflation data points to better inflation outcomes. Raw materials prices have increased for the seventh consecutive month (ISM manufacturing). Moreover, house price appreciation continues unperturbed, suggesting that rents and owners’ equivalent rent of residences (with a cumulative CPI weight of 41%) have further room to run from their current velocity (2.3% year-over-year). Last but not least, US banks appear to move away from substantially tightening in corporate lending standards (see graphs below).
Long-term nominal yields have increased by less than breakevens (+27 bps to 1.18%) since US Elections. With short-term rates anchored by the Federal Reserve, the Treasury curve (10/2s) has steepened above 100bps -- a boon for banks’ profitability going forward -- reaching its widest level since mid-2017. From a valuation perspective, US Financials are trading at 1.4x their Book Value of equity (69% percentile) compared with 4x for the US market (100% percentile).
In a world where $17 trillion of fixed income is priced at negative yields, euro area periphery bond spreads remain attractive due to, inter alia, supportive monetary policy. The latest political developments in Italy bode well for the asset class, as Mr. Draghi has been tapped to become Italy’s next Prime Minister. The 10-Year BTP/Bund spread narrowed below 100bps for the first time since January 2016.