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Equity market meltdown unlikely if central banks act according to expectations

07 July 2021 Seeiso Matlanyane, Equity Portfolio Manager and Analyst at Prescient Investment Management
Seeiso Matlanyane, Equity Portfolio Manager and Analyst at Prescient Investment Management

Seeiso Matlanyane, Equity Portfolio Manager and Analyst at Prescient Investment Management

The big topic in equity markets, particularly in the US where stock markets continue to reach new highs, is whether extended valuations are signalling that a big meltdown is in the offing.

Trying to predict the future is exceptionally difficult, particularly at a time like this when COVID-19 has taken the markets into uncharted territory. The safest and easiest answer would probably be yes, because based on recent market history there has been a meaningful correction every 10 to 20 years or so. Unfortunately, it is not that easy, the remarkably strong price action that we have witnessed recently does not necessarily mean a meltdown is coming any time soon.

The key concern for investors seems to be the perceived overvaluation of equity markets, which have had an exceptionally strong run since last March when the COVID-19 pandemic hit Italy hard and then spread across the world. Adding to that, markets had already had a strong run in the lead up to the pandemic. With the massive government and central bank stimulus programmes underpinning economies and financial markets, equity markets have managed to recover to pre-COVID levels and more. The concern is therefore whether stock prices have outpaced their earnings potential and therefore multiples are unsustainably high.

When these multiples are simply compared to their historical values it is true that these are elevated. However, there are other things that need to be considered when assessing what the outlook for the equity market is likely to be and then making a call. These include financial conditions, market sentiment, behavioural biases, earnings quality and many others.

Yes, valuations are high, but this is largely because of unusually expansive financial conditions. Trillions of dollars of stimulus have been released into the financial markets through government spending and monetary policy actions. Central banks have acted far more swiftly, decisively and in greater magnitudes than they did when quantitative easing was first introduced in the wake of the 2008 financial crisis.

At that time there was a lot of hesitation because these initiatives were not in the traditional monetary policy textbooks and thus called for caution. Additionally, there was an overhanging moral hazard at the time as the big banks were essentially being bailed out by the authorities. However, now the central banks have a playbook and that has enabled them to act far quicker and definitively.

Naturally, valuations are determined by the prevailing stock prices relative to expected earnings, which incorporate expected interest rates. Interest rates have collapsed as a result of these monetary policy stimulus measures and that has pushed up valuations because earnings are discounted at the much lower interest rates.

This is why inflation and interest rate expectations have taken centre stage during the first half of the year. Central banks currently have their foot firmly planted on the accelerator and are maintaining low interest rates in the hope that the economy will keep going. However, the prevailing view is that they cannot do this forever because naturally the economy will start overheating. With access to funding and cash super easy, at some point this is going to feed through to the economy and inflation is going to pick up.

The concern is that, at these valuations, rising interest rates could trigger a massive equity market sell off. However, we believe central banks are not going to start increasing rates until they are certain that the economy will not stop functioning without monetary policy support. They have indicated they are willing to let the economy overheat a little and allow inflation to tick up because they understand the importance of not removing the punch bowl from the party too quickly. We do not expect that to happen anytime soon, perhaps in nine to 18 months’ time.

Markets are always forward looking, and we believe that if the central banks act within expectations, the market will not be shocked, and we will not see a meltdown because their actions would have been incorporated into the price.

As a systematic investor, that works into our hands. Statistics are available to everyone, but it is about how quickly you can get hold of the information and form a view. Thus, it is the technology that allows you to take informed decisions most efficiently and assuredly. We are investing a lot into big data technology to enable our investment decisions during a time where we believe process over the person puts us in the best position to deliver consistently superior investment results on behalf of our investors.

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