Strong PMIs and the acceleration in the pace of vaccinations, point to a more favorable path for the euro area economy
The composite euro area PMI index rose by 3.1 pts to 56.9 in May, the highest since February 2018, well above the expansion/contraction threshold of 50, overshooting consensus estimates for 54.8 and suggesting that euro area economic growth is set to accelerate in H2:2021.
Reflecting an improved outlook, euro area core Government bond yields have increased by circa 50 basis points year-to-date, albeit from ultra low levels. President Lagarde’s dovish comments that it is too early to discuss winding down the pandemic emergency purchase programme, suggest that the ECB will be vigilant against a premature tightening of financing conditions.
The latest ECB’s Financial Stability Review (FSR, May 2021) commented about “remarkable exuberance” in equity markets, an expression reminiscent of the former Fed Chair Alan Greenspan’s “irrational exuberance” speech (1996).
Current conditions in global financial markets, have also led some investors to draw comparisons with past periods of excessive enthusiasm, albeit real interest rates are now significantly lower than 1996, justifying the shift of portfolio allocations to more risky assets.
Elevated valuations though, make equities vulnerable to “unexpected and prolonged contractions”. The S&P500 has surged by 86% since its March 2020 lows, while the Price/Earnings (P/E) ratio stands at 21.3x (94th percentile), compared with pre-pandemic level of 19.3x. The EuroStoxx index has increased by 64% during the same period. The P/E of 18.1x ranks at the 94th percentile, compared with 16x pre-pandemic.
A sharp hike in interest rates “could prompt an adjustment in risk asset valuations, with possible adverse implications for financial stability” (FSR, May 2021). A 10% correction in the US equity market due to a US monetary policy tightening shock, could possibly lead to an immediate decline of 9% in its euro area peers. Speculative-Grade corporate bond spreads could widen by 245 bps in an eight-week period (Investment-Grade: +39 bps).
According to the minutes of the April 28th FOMC meeting, a number of participants (albeit not the Fed’s leadership) suggested that if the economy continued to make rapid progress toward the Committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases. Chair Powell though, reiterated that the economy is still long away from Fed’s goals.
“Signs of exuberance” have also been present in the crypto-asset market, with Bitcoin price surpassing the $60.000 milestone in April, overshadowing by a wide margin previous episodes of extreme price appreciation such as the “Tulip mania” in 1637 and the South Sea Bubble in 1720.
Bitcoin price has declined by 44% since its April high to $36,000, inter alia, due to (i) China’s decision to ban financial institutions and payment companies from providing services related to cryptocurrency transactions; (ii) increased scrutiny by regulators (US Treasury proposed that the cryptocurrency transfers of at least $10.000 should be reported to the IRS) and E. Musk’s statement about Tesla no longer accepting Bitcoin as a means of payment.