Interest rates and bond yields are, and will remain, record-low even in a long-term perspective. This situation is essential if today's historically high stock market valuations (price/earnings ratios of around 22 for the S&P 500 and 23 for the leading Stockholm equity index) are to be viewed as reasonable − and even capable of climbing higher − without turning out to be a bubble. Central banks are the most important guarantors of continued stock market rallies. This is especially true of the US Federal Reserve (Fed).
Federal Reserve announces new monetary policy guidelines
At last week's big annual central bank conference, hosted virtually by the United States, Fed Chairman Jerome Powell delivered new guidelines for US monetary policy. First, the labour market will play a less prominent role than previously in setting the key interest rate, reflecting the fact that the Fed no longer believes in the classic correlation described by the Phillips curve (low unemployment leads to high inflation and vice versa). Looking ahead, inflation figures in themselves will be important to how interest rates are set.
Second, the Fed will now target an average of 2% inflation over time, rather than keeping 2% as a fixed goal. If inflation is below 2% − as it has been in recent years − this may be followed by a period of inflation above 2%. Analysts are interpreting this as a way for the Fed to signal that its interest rates will remain low for a long time, even if inflation should climb in the near term.
One interesting question is whether other central banks will follow the Fed's example. There are many indications that this will be the case, although it may take time before these changes are formalised. Several Executive Board members at the Riksbank have stated, with varying degrees of clarity, that the Swedish central bank will allow inflation to exceed its own 2% target for a period of time and that this would even be desirable.
New inflation target will have little impact on interest rates and yields
The announcement that future US monetary policy will be based on average inflation did not affect market expectations to any great extent, probably because of already low expectations of key interest rate hikes over the next few years. The market is currently expecting no Fed rate hike for about 4-5 years. Long-term market yields rose after the Fed announcement, and we believe that yields will keep rising slightly during the rest of 2020.
Our market view
The stock market upturn of recent months has largely been driven by "digital dragons": mainly US-listed technology companies. Their share of overall market capitalisation has increased − which in itself poses a risk − and their valuations have climbed to historically high levels, but these companies are also showing large profits and very rapid earnings growth, not least due to the current worldwide digitisation megatrend. This suggests that today's valuations are defensible.
For the market as a whole, there are also other risks besides high valuations. New virus outbreaks will increase the risk of new lockdowns. These will probably be on a smaller scale than last spring, but if there are many of them they can still have an impact on growth. Geopolitical uncertainty is another negative factor, especially US-Chinese tensions and the US elections, as well as Brexit (British withdrawal from the European Union) and difficulties in EU cooperation. On the positive side is the relative strength of second quarter corporate earnings reports, which surpassed low expectations, as well as the powerful stimulus measures that governments and central banks have launched and the outlook for a COVID-19 vaccine and/or new stimulus packages.
Looking ahead, we expect continued low interest rates and bond yields – as well as a slow return to more normal growth trends – to help sustain stock markets. We thus have a cautiously optimistic view of risk assets such as equities, and we are maintaining our hypothesis that stock market downturns can be regarded as buying opportunities.
Returns on corporate bonds have climbed sharply since last March's price decline and have greatly exceeded our expectations. Their future potential is thus not as strong as before, but we are still positive towards owning corporate bonds, especially those with a sustainable focus.