In a post published on January 25th, Evidente recommended that investors take a tactical overweight bet in global equities and risk assets more broadly (see Super Mario to the rescue? Not just yet). Despite equity valuations being stretched, the positive view was based on the prospect that the ECB and Bank of Japan had signalled to the market that more stimulus was on the way to combat renewed disinflationary forces and anaemic growth. I suggested that there was also upside to risk assets thanks to the increased likelihood that members of the FOMC would have little choice but to downgrade their projections for the federal funds rate due to core inflation continuing to undershoot its target by such a long way and preliminary signs that indicators of manufacturing activity were tipping over.
Since then, global stock markets have rallied, with the MSCI World delivering a return of plus 7%, led by the S&P500 which has lifted by over 8%, while US Treasuries have risen by less than 1% (see chart).
During this period, both the ECB and BOJ have delivered more stimulus, although the nature of the expansion of their respective QE programs has surprised market participants. At the end of January, the BOJ announced that it would introduce a marginally negative interest on incremental or new reserves that commercial banks hold at the central bank. More recently, the ECB announced that it would expand its asset purchasing program to 80 billion euros per month (up from 60 billion euros) and also start to purchase investment grade euro-denominated non-bank corporate debt securities.
The other key development overnight was a material change in the now closely watched dot charts from the US Federal Reserve, which denote the FOMC members' interest rate projections. This shows that ten of the seventeen members now expect the federal funds rate to be below 1% by the end of this year, and nine members are forecasting the rate to be below 2% by the end of next year (see chart).
This represents a significant shift in the central bank's internal expectations. As recently as the FOMC meeting in mid-December, only four members expected the rate to be below 1% at the end of this year and five members were forecasting a sub-2% rate by the end of 2017 (see chart).
The FOMC statement overnight suggests that the benign inflation outlook has underpinned the more dovish stance. The Committee cites the shortfall in core inflation relative to its medium term target of 2% and highlights that market based measures of inflation compensation remain low and survey based measures of longer-term inflation expectations are little changed. Evidente has taken the opportunity to update its econometric model of US core inflation. Assuming that oil prices and the US dollar remain unchanged from current levels, core inflation is forecast to increase over the course of this year but still remain well below the central bank's 2% target by year end (see chart).
Following the rally of recent months, the S&P500 is now trading above 16x consensus 12 month forward EPS, which is expensive by the standards of the past five years (see chart). Given that the ECB and BOJ have expanded their QE programs in recent months and the Federal Reserve has effectively delivered more stimulus by pushing out the timing of policy 'normalisation', I believe that the scope for further multiple expansion of US and global equities in the near term is limited. Upgrades to growth prospects are therefore necessary to drive the market higher but the evidence in the US isn't encouraging; consensus EPS forecasts for the S&P500 are at the same level that prevailed in mid-2014 (see chart). Against this backdrop, Evidente recommends that investors neutralise their tactical bet in global equities and risk assets more broadly.