The dichotomy between economic and market trends has widened, in a context of accommodating monetary policy and rising corporate debt. Risks taken by institutional investors (pension and investment funds, life assurance companies) have increased, as has the vulnerability to any adverse shocks or changes in expectations. 2020 – an election year – is unlikely to bring calm. Welcome as it is, the truce in the trade war with China takes in the bulk of existing tariff increases, without producing any fundamental changes in the position of the US administration and its limited appetite for multilateralism.
One is taking off, the other coming in to land. Whilst the US economy has been on a slowing trajectory for more than a year now, with the industrial sector dropping into recession, the equity market is still setting new records. In 2019, the Standard & Poor’s index of the 500 biggest listed companies gained nearly 30%; at 3,230 on 31 December it was 106% above the record high of October 2007. The Nasdaq tech stocks index surged by 35% in 2019, taking its gains over the past seven years to 200%.
Higher, faster, riskier
Is this irrational exuberance? The fact is that in the United States, rising equity prices display a fairly distant relationship with the slower growth in earnings, resulting in stretched valuations (Figure 2 and IMF, 2019)1 . With interest rates remaining low, equities’ gains are based on an amplification of the leverage effect. In its latest Global Financial Stability Report, the IMF highlights the importance of borrowing in M&A activity and in share buybacks. The increase in the weighting of goodwill in total assets, and the high multiples used in LBO (leveraged buy-out) deals reflect increasingly ambitious bets on the future2 . Increased risk taking can also be illustrated by the narrowing of spreads on high-yield debt (Figure 2), a market sector that the IMF also considers to be overvalued.
In the current phase of rising asset prices, institutional investors (investment and pension funds, life assurance companies) have played an increasingly important role. Whilst banks have, overall, slowed the expansion of their balance sheets and improved their resilience since the 2008 financial crisis, institutional investors have expanded their activity, taking a growing share of financing. They have also widened the scope of their quest for returns, in a context of falling interest rates on sovereign debt, the traditional core of their investment portfolios. A reallocation has taken place, away from cash and investment-grade bonds, to less liquid and more risky assets such as unlisted private debt, real estate and infrastructure. This has produced greater vulnerability to negative shocks or changes in expectations.
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