Momentous Markets and Rallying Securities: Should Investors be Skeptical?

Bullish sentiments, embraced inflation, and risky emerging markets. 

Forecasts of stronger earnings growth by analysts have investors excited. Are rallying markets a sign that valuations are becoming too “stretched?” Valuations make sense right now, because of how low interest rates are.  

The Central Bank’s ability to reduce market volatility through lower interest rates plays a significant role in the recent optimism felt by financial markets. As the US Federal Reserve continues to keep interest rates low, a rising number of Wall Street players caution that consequences of loose monetary policy, specifically inflation, could have serious negative effects, namely the development of new risks.  

Concern for inflation from the Fed “would certainly make a reversal from the past decade or so, when market watchers [were] more bothered about deflation” expressed Financial Times writer Jennifer Ablan. A decrease in prices and cost of living, brought on by deflation, encourages central banks to stimulate the economy, which they fear is be “slowing down”. The threat of descending into a low-growth low-inflation economy has resulted in Jerome Powell, Chair of the Federal Reserve, to encourage higher levels of inflation. 

The US Federal Reserve cut interest rates three times in 2019, decreasing its target range for short-term borrowing from 1.75 % to 1.5 %.  

This liquidity injection has fueled asset markets. As proved by market trends in the past, this tends to end up quite badly. Kristina Hooper, global market strategist at Invesco stated earlier this week for the Financial Times that “this rally has been driven almost entirely by the Fed articulating in no uncertain terms that the bar is very, very high for it to raise rates again ... that has been the jet fuel propelling this most recent run-up in the stock market”.  

This extra easing from the Fed, combined with liquidity injections left investors feeling optimistic, in other words “bullish,” while also creating valuation problems and heightened expectations for 2020, explains Andrew Lapthorne, head of quantitative equity research at Société Générale. Low interest rates have created an environment that invites the formation of an asset bubble: a rise in price, unsupported by the inherent value of the product. The result? Valuations that fail to reflect real and sustainable value as investors continuously bid-up asset prices. 

The Federal Reserve’s policy change from 2018 to 2019 largely explains the gains observed in last year’s stock market. The Fed, having raised interest rates four times in 2018, saw a reversal in strategy last year, as it lowered rates to historical lows on three occasion. Falling interest rates largely decreased the attractiveness of bonds as investors sought out yield, pushing funds into stocks, which were expected to appreciate.  

As seen by the S&P 500’s performance, equities have been on the rise for over 10 years, but is low inflation the only catalyst in propelling global equity indices to record heights? Trade tensions between the US and emerging markets such as China have pushed forward the rise.  

Early last month the US and China signed Phase 1 of a deal that paused the trade war and led to further investor optimism. The signed agreement included Beijing committing itself to the purchasing of $200 billion in US goods and services in exchange for Washington’s reduction of tariffs on $120 billion worth of Chinese products. This deal offered investors some relief following the trade tensions between the two powers, particularly reducing anxiety tied to business uncertainty during the lengthy conflict.  

Investors should not be too happy quite yet. Uncertainty in the global market still looms, particularly between these two economic powerhouses. Truces are fragile and the prospect of renewed conflicts should not be so easily dismissed.   

Still, investors remain enthusiastic with emerging markets. Why? Infusion of liquidity from global central banks combined with easing trade tensions has created an environment that is likely to continue on sustaining gains. Negotiations for Phase 2 of the trade agreement were said to start soon by President Trump. While no specific date has been mentioned, it is expected that Phase 2 of the US-China Trade deal will contain yet another round of tariff reversal. As for inflation, only a significant and persistent increase in inflation would result in the raising of rates by the Fed to address concerns.  

For now, investors can remain upbeat and expect further gains from presently rallying markets.