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American stocks look bubbly. At nearly 40 times backward-looking earnings, the price-earnings ratio of the S&P 500 was higher only once in history, just before the 2000 tech stock crash. If it’s a bubble, though, it’s a rational bubble driven by two factors that are easy to visualize in the charts below.
The first is China’s economic rebound, which has boosted global demand for commodities and sustained pricing power in world markets.
The second is the unprecedented level of securities purchases by the US Federal Reserve, which has kept real interest rates well below zero for the past year. When you have to pay the government or banks to hold your money for you, and a Treasury bond pays you less principal after inflation than you originally invested, stocks look good, even at prices that would be insane by any normal standard.
What are investors supposed to do? The answer is: Buy cheap stocks with reasonable growth potential. There’s only one index in the world that meets both criteria, and that’s the Hang Seng China Enterprises Index (so-called H-shares of Chinese companies).
As shown below, the “forward” price-earnings ratio of the CSI 300 Index is around 16, compared to 23 for the S&P 500. The HSCEI has a price-earnings ratio of only 10. That’s due in part to the fact that HSCEI is more weighted to financials, whose P/E is chronically low, and in part to the underperformance of H-shares relative to A-shares.
Part of the underperformance of H-shares is due to uncertainty about the status of Hong Kong stocks owned by US investors. We think this uncertainty will dissipate over time with the incoming Biden Administration.
At first glance, there doesn’t appear to be much of a relationship between Treasury yields and the price of US stocks. Shown below is the nominal 5-year Treasury yield vs. the S&P 500.
But there are two components to the Treasury yield, namely expected inflation and the “real” yield, that is, the yield on Treasury Inflation-Protected Securities, whose payout is indexed to inflation. The difference between the TIPS yield and the nominal yield is called “breakeven inflation.” That’s the inflation rate (measured by the US Consumer Price Index) at which an investment in TIPS breaks even with the yield on nominal Treasuries.
Remarkably, the S&P 500 Index has traded in a near-perfect line with real yields and inflation expectations.
Let’s take these two elements of the Treasury yield one at a time. The expected inflation rate (“breakeven” inflation) is easy to explain: It tracks the global level of commodity prices, which rise with global demand.
That’s where China calls the shots. China’s economy grew by about 2% in 2020 while the US, Europe and Japan shrank by about 6%. China is the main source of demand, and its demand for oil, coal, iron ore, copper and other commodities is the main support for commodity price indices.
The other factor is the “real” yield on Treasuries. If investors lose money after inflation buying US Treasuries (or their European and Japanese counterparts), equities become all the more attractive. That’s why we see a nearly linear relationship between the real 5-year Treasury yield (the yield on TIPS) and stock prices.
The “real,” or TIPS yield, is negative because the Federal Reserve has cut its overnight lending rate to zero, and even more because the Fed bought an astonishing $3.5 trillion of bonds during 2020. It’s clear from the next chart that TIPS yields fell below zero when the Fed opened the floodgates.
While it was buying trillions of dollars of bonds from the market, the Fed also cut the overnight interest rate to zero, and the futures market in this rate (federal funds) shows that the market expects it to stay at zero forever. This also pushed real rates down.
A short-term interest rate of zero puts a cap on the overall level of interest rates, at least in shorter maturities. As the expected Fed overnight rate fell to zero, the 2-year Treasury yield fell to just above zero and the 5-year Treasury yield remained stuck at 40 basis points (or 0.4 percentage points).
The Fed more or less fixed the nominal Treasury yield. But inflation expectations rose as China’s economy recovered and pushed up commodity prices. As inflation expectations rose, the real component of the Treasury yield had to fall.
As we see from the chart below, the pop in inflation expectations (“breakeven inflation”) was matched by a collapse in real yields.
The combination of collapsing real yields and rising inflation expectations explains virtually all of the stock market rally.
For currencies that are keyed to commodities, the rise in commodity prices provided a tailwind. The Australian dollar, a “commodity currency,” traded in a straight line with commodity prices during the past six months.
What could go wrong?
First of all, the Federal Reserve could decide that it can’t risk another few trillion dollars’ worth of bond buying during 2021. A number of brokers, for example, J.P. Morgan, predict higher US bond yields simply because the supply of US Treasuries will overwhelm the Fed’s willingness to buy them. America’s budget deficit is projected to reach 15% of Gross Domestic Product during 2021, a number never seen except during World War II, as the federal government hands out support checks to a still-weak economy. That’s over $3 trillion dollars in net Treasury supply. Foreigners have stopped buying US Treasuries altogether (why should they at a negative real yield?). Banks can manage a few hundred billion. US households can’t take down the rest. The Federal Reserve would have to maintain its multi-trillion-dollar buying binge, or Treasury yields will rise sharply. Our view is that fears of Fed inaction are overblown. With the US economy still weak, and facing a worse-than-ever second wave of COVID-19 infections, the Fed will not risk even the mildest perception of “tapering” of support for the bond market.
China’s rebound from the brief COVID-19 slump is more or less complete. The Chinese economy is expected to grow by 8%-9% in 2021, but the rate of growth will have to decline as the recovery matures. Commodity prices probably will peak early 2021. Among liquid assets, the Aussie Dollar is most exposed to commodity prices. Investors looking for an inexpensive hedge against a prospective equity market correction might consider shorting the Aussie dollar while owning Chinese stocks, preferably the cheaper H-shares.