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Stealth rally in equities is out of step with reality

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Born in Cape Town, Natale Labia lives in Milan, Italy, and writes on the economy and finance. Partner of private equity firm Lionhead Capital Partners. MBA from Università Bocconi. Supports Juventus.

Since early 2020 and the onset of the Covid-19 pandemic, one narrative has been central to market dynamics. With low bond yields in the US and Europe, returns on fixed income (particularly in real terms when adjusted for inflation) have been dismal. Investors have therefore repeated, ad nauseam, that 'there is no alternative' to owning equities.

This has underpinned an unwaveringly dogged and relentless expansion of equity markets. The S&P 500, the US benchmark index, is up 104% in two years from its pandemic nadir in March 2020. The liquidity gushing from the pandemic-era fiscal and monetary policy largesse had to flow somewhere. With yields so low and the dividend yield on equities relatively attractive by comparison, and with the ultralow discount rate from treasuries making ever loftier valuations justifiable, the waves of cash flooding into equities have been unrelenting.

In early 2022, these dynamics started to change. First was US Federal Reserve governor Jerome Powell’s about-turn. After his reappointment by US President Joe Biden in November 2021,  he clearly felt empowered and emboldened to swing the rate-hiking bat for the boundary. He doubled down on his intention to hike relentlessly until the inflationary beast had been tamed and markets were caught offside as equities experienced a sharp correction in January.

Second was Russian President Vladimir Putin sending his tanks into Ukraine. This compounded equity market selling as commodity prices rocketed, making protracted stagflation in late 2022 all the more likely.

Finally was the long-awaited correction in the bond markets. Having been relatively steady through the maelstrom of the first few months of 2022, by March the bond market was determined to make up for lost time. Rarely has the usually placid and staid environment of the multitrillion-dollar US treasury market seen such abrupt and ferocious moves, with the US 10-year benchmark bond leaping by 85 basis points to around 2.5% (bond yields move inversely to prices). Portfolios of investors who sought shelter in fixed income were hammered.

Surely these substantial and aggressive market moves give cause for reconsideration of the there is no alternative (Tina) narrative? Simply put, being able to lend risk-free to the US government in dollars for 10 years at 2.5% must mean that, for the first time in more than two years,  investors do have an alternative to marching lemming-like, waist-deep, into the bloated valuations offered by the S&P 500 and other global equity markets?

If that is the case, investors don’t seem to be grabbing the opportunity. Indeed, what has transpired over the past few weeks since the bond rout is surprising. Instead of rising bond yields forcing further reconsideration of equity valuations and a gradual move from equities towards fixed income, investors have seen the sell-offs from the Ukraine war and the rise in bond yields as an equity-buying opportunity.

What has transpired is a stealth rally in equities, with the S&P 500 up almost 6% in the past month, and the growth-focused and tech-heavy Nasdaq up almost 10%.

The JSE too has experienced much the same. While it was protected against the rapid market correction earlier this year by its rocketing resource stocks such as Amplats, Anglo American and BHP, it consolidated those gains in March. Among the best performers on the local bourse over the past month have been staid financials such as FirstRand and Standard Bank.

There are several conflicting dynamics at play. First, for investors to move with conviction from equities to bonds, they would have to be confident about future inflation expectations. Inflation is bad for stocks but much, much worse for bonds. If investors are reluctant to move into the 10-year Treasury, which is what the inverted yield curve is saying, it could be that they are seeing equities as a better hedge against inflation.

Second, for local investors, the rally in equities is highly sector specific. Some sectors that have been oversold or stand to benefit from a rising interest rate environment (such as financials) have been stellar, whereas others – Chinese tech exposed Naspers, for example – remain unloved, trading where it was in mid-2017. As far as financials go, this could be premature. While rising interest rates will benefit banks now, higher interest income and an economic slowdown later in the year could hurt much more through higher provisions.

Finally, SA Inc is increasingly becoming SA Commodity Exporter Inc. The positive narrative on the South African economy and domestic stock market is increasingly predicated on one thing: lofty commodity prices.

These underpin a lower budget deficit, sovereign debt sustainability, burgeoning current accounts and a stable rand. Unemployment might be at an all-time high and economic growth moribund but the market does not care, as long as those margins and tax revenues on exported iron ore, platinum and gold remain robust.

For those savvy investors who have remained invested in equities over the past trying few months and recent stealth rally, this market recovery could be an opportune moment for portfolio rebalancing.

In South Africa, uncertain times lie ahead. It is unlikely commodity windfalls will continue to be so generous. Darkening clouds over the economy in late 2022/23 could make current equity valuations look heady by comparison. Rising interest rate bear markets usually persist for months; we are in all likelihood right at the beginning of this cycle. Now that there is an alternative to equities, selective de-risking and profit-taking seems a sensible move. DM168

This story first appeared in our weekly Daily Maverick 168 newspaper which is available for R25 at Pick n Pay, Exclusive Books and airport bookstores. For your nearest stockist, please click here.

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