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Why Investors Can’t Agree on Financial Outlook

T.he is a quokkaAbout the size of a domestic cat, Australian marsupials have lush cheeks and curved mouths that often give willing tourists the impression that the animal is smiling. They are said to be the happiest animals on earth. Lately, however, there has been competition from another race: American equity investors.of s&p The 500 is already up 14% this year. A further 10% rally would send the index back to its all-time high set in January. Excitement about artificial intelligence is igniting companies that are seen as potential beneficiaries.

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Rising stock prices represent a dramatic upturn, but not the most surprising market change. That prize goes to the collapse of volatility. in the last 12 months, Vicks, the index, which uses the cost of insurance against extreme movements to measure expected volatility in stock prices, fell by more than half, from about 30 to 13. The last time there was such a drop was in early 2020, before the financial crisis hit. During Covid-19, fears of economic stagnation were more common than fears of inflation. Considering that Vicks is sometimes called the “fear gauge,” and its low levels suggest a quokka-like calmness in the stock market.

The prospect is even more surprising given the myriad of things investors can worry about. For example, there is a great deal of uncertainty about what the Federal Reserve will do next, and investors may well want a little more protection.When s&p The 500 reached an early peak in 2021, a period of high volatility when the Federal Funds rate was at zero (currently 5%) and the 10-year Treasury yield was 1.5% (currently 3.7%). Additionally, high rates can break other things. The recent turmoil in U.S. banking was barely on investors’ radar screens until days before the failures of Silicon Valley Bank and Signature Bank. Another financial institution, First Republic, collapsed in early May. Today’s optimism makes it hard to remember that those problems were only recent.

But there is another species that seems less gentle. If stock investors are the quokkas of the financial kingdom, bond investors are the porcupines with a wary and naturally defensive nature.decline of Vicks are in stark contrast to their counterparts in the US Treasury market. Although, move An index that tracks insurance prices against bond market volatility is down from a 13-year high in March but still double its pre-corona levels. Bond investors aren’t yet convinced the boom is back.

The difference in sentiment between quokkas and porcupines is very different from the early stages of the pandemic, when stocks were extremely volatile but government bonds were much less volatile. At the time, investors were preoccupied with the economic impact of COVID-19, vaccine development and deployment, and the pace of economic reopening. Then inflation accelerated and Fed action became the overwhelming focus.

Observing the difference, it may be tempting to conclude that either the bond or the stock market must be wrong. But that’s not quite right. The emergence of artificial intelligence as a force that transforms the profits of big tech companies, rather than the growth of the economy as a whole, would be a boon for equity investors but little for government bonds.

The problem is that such an outcome is far from certain, and investors are starting to price stocks based on returns that are unlikely to materialize anytime soon. The price-earnings ratio is s&p The 500, based on expected earnings over the next 12 months, has risen from under 16 at the end of last year to 19 today. That’s still below the highs it set when earnings expectations were dampened by lockdowns and restrictions during the pandemic, but higher than at any point in the last 20 years.

The difference in animal spirits speaks to the fact that stock market investors, mistakenly or not, have left behind concerns that dominated their minds just a few months ago. They exchanged various concerns to create an optimistic narrative about artificial intelligence. The rosy outlook implied by the lack of volatility is not only that the new technology will eventually become a revolutionary moneymaker for U.S. public companies, but that the Fed’s decision will not destabilize the financial system again, and the economy will continue to grow. It is also a judgment that the economy can withstand the impact of the financial crisis. Interest rates rise. As it stands, this looks like a bold bet.

Read more from financial markets columnist Buttonwood:
America’s financial system could collapse sooner or later (June 15th)
Soaring stock market is powered by artificial intelligence (June 7)
Investors are back in the fight against rising interest rates (June 1)

Related article: How batonwood columns work got that name

https://www.economist.com/finance-and-economics/2023/06/22/why-investors-cant-agree-on-the-financial-outlook Why Investors Can’t Agree on Financial Outlook

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