Appetite for risk and the US stock market - Capital Economics
Capital Daily

Appetite for risk and the US stock market

Capital Daily
Written by John Higgins
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Even if a lot of good news is now embedded in the US stock market, we still think that it will make some more headway over the coming year. Our end-2021 forecast for the S&P 500 remains 4,200, which is ~9% higher than its level now.

  • Virus restrictions probably weighed on euro-zone retail sales in January (10.00 GMT)
  • We expect Malaysia’s central bank to cut its policy rate by 25bp (07.00 GMT)
  • View our highest conviction macro calls and their market implications here

Key Market Themes

Even if a lot of good news is now embedded in the US stock market, we still think that it will make some more headway over the coming year. Our end-2021 forecast for the S&P 500 remains 4,200, which is ~9% higher than its level now.

One way of judging how much good news is priced into the stock market is via the risky part of the rate at which corporate earnings are discounted.

Unfortunately, this risky part – aka the equity risk premium – cannot be observed directly. Nonetheless, we can surmise how it has evolved by looking at the risk premia of corporate bonds. They suggest a lot of good news has now been discounted over the past year or so.

Chart 1: Breakdown Of Estimated US 10Y Investment-Grade Corporate Bond Real Yield vs. S&P 500

Sources: Refinitiv, CE

After all, an average of the option-adjusted spreads (OAS) of ICE BofA ML’s indices of 7-10 year and 10-15 year US investment-grade corporate bonds has plunged from over 4% in late March 2020 to barely above 1.1% now, which is lower than it was before the pandemic. Chart 1 bolts this average onto the 10-year TIPS yield to produce an estimated 10-year US real corporate bond yield. As this yield has fallen, so the S&P 500 has risen.

Of course, the risk premia of corporate bonds and equities will not have evolved in precisely the same way over the past twelve months, even if they have headed in the same direction. But that aside, Chart 1 suggests that significant further upside in the stock market would require an extra decline in risk premia in the absence of real government bonds yields dropping back.

We would not rule this out. Just because the risk premia of US corporate bonds, for example, are lower now than they were before the pandemic does not preclude them from falling further. And we have made the case that the sustainable level of credit spreads may be lower now than in the past. (See here.)

What’s more, even if investors’ appetite for risk is nearly sated at this point, we wouldn’t be surprised if the “risk-free” part of the earnings yield, which in the US can be proxied by 10-year TIPS yield, continued to edge back down after its recent surge. This is because Fed officials are likely in our view to continue to stress that they intend to keep the real stance of monetary policy exceptionally loose for years to come.

Having said all of that, Chart 1 does suggest to us that future gains in the US stock market will increasingly rely on increases in earnings rather than on the rate at which they are discounted.

Notwithstanding a bright outlook for economic growth, we think this would be consistent with the stock market grinding higher from here rather than soaring. (John Higgins)

Selected Data & Events




CE Forecast*

Thu 4th


Consumer Confidence (Feb.)






Interest Rate Announcement






IHS Markit/CIPS Construction PMI (Feb)






Unemployment Rate (Jan)






Retail Sales (Jan)






Non-farm Productivity (Q4, Final)





Unit Labour Costs (Q4, Final)




*m/m(y/y) unless otherwise stated; p = provisional

Key Data & Events


The surprise fall in the ISM services index to 55.3 in February, from 58.7, is at odds with the continued easing of virus restrictions and recent boost to incomes from fiscal stimulus. But it does indicate that the severe winter weather across much of the US weighed on activity. That fall was partly driven by a drop in the employment index which, alongside the muted 117,000 increase in the ADP measure of private employment, suggests that there are downside risks to our forecast that the official payrolls figures due on Friday will show a 500,000 gain.

Regardless, the strength of January’s hard data means we already know that GDP growth is likely to accelerate in Q1, with a further pick-up likely in Q2 as vaccines allow for a widespread reopening of the economy. Indeed, we learned on Tuesday that the supply of vaccines will be even stronger than previously thought, with President Biden’s use of the Defence Production Act to help speed up production of one major new vaccine meaning that the US is now expected to have enough doses for all adults by the end of May. (Andrew Hunter)


The small upward revision to the euro-zone’s composite PMI for February still leaves it consistent with another contraction in GDP in Q1. And while Italy’s PMI rose above the 50-mark, that is unlikely to be sustained given that a rise in virus cases there is prompting the government to tighten restrictions again. Other data released on Wednesday showed that Switzerland’s inflation was unchanged in February, at minus 0.5%. Temporary forces look set to push it higher over the coming months. However, with underlying price pressures likely to remain much weaker, the SNB will keep its policy rate rooted at its current record low for the foreseeable future.

We expect data due on Thursday to show that euro-zone retail sales remained more resilient in January to virus restrictions than they did last spring, falling by just 1% m/m. That’s said, the weakness of Germany’s retail sales data for January earlier this week suggests that the risks to our forecast are to the downside. Meanwhile, we suspect that the euro-zone’s unemployment rate held steady at 8.3% in January.

In the UK, the Chancellor’s Budget provides more near-term support for the economy than we had expected. The long list of extended support schemes adds up to a loosening in fiscal policy relative to previous plans of about £54bn (2.6% of GDP) in 2021/22. But it also uses higher taxes from 2023/24 to reverse support quicker. This means the budget deficit declines almost back to pre-pandemic levels by 2025/26. The upshot is that taxes may not need to rise much further than is currently scheduled. (Melanie Debono & Kieran Tompkins)

Other Developed Markets

The 3.1% q/q rise in Australia’s GDP in Q4 left output just 1.1% below pre-virus levels, and we think it will surpass that threshold by Q2 of this year. (Ben Udy)


The Caixin services PMI dropped from 52.0 to a ten-month low of 51.5 in February, mirroring falls in the official PMIs and Caixin manufacturing index. These suggest that travel restrictions over the Spring Festival weighed on activity last month. But the big picture is that, with output well above trend at the end of 2020, the slowdown in momentum implied by the recent PMIs is still consistent with robust economic activity last month. (Sheana Yue)

Other Emerging Markets

In Emerging Asia, we think that recent volatility in global financial markets will dissuade the Central Bank of Sri Lanka from easing policy on Thursday. The nation’s large current account deficit and high level of foreign currency debt makes it vulnerable to shifts in risk appetite. But given the poor economic outlook, we expect interest rate cuts later in the year. Meanwhile, we expect the headwinds from Malaysia’s second wave of COVID-19 to prompt its central bank to cut its main policy rate by 25bp, to 1.50%.

In Latin America, Brazil’s Q4 GDP figures showed that output expanded by a stronger-than-expected 3.2% q/q and confirmed that the economy was less severely affected last year by the pandemic than others in Latin America. But there are clear signs of a slowdown so far this year and Brazil’s latest COVID-19 outbreak casts a dark shadow over the near-term outlook.

In Emerging Europe, data released on Wednesday showed that Turkey’s inflation rose to 15.6% in February. Although we expect inflation to fall steadily over the next six months, the central bank may feel the need to hike interest rates in order to retain investors’ confidence if the lira comes under renewed pressure in the coming weeks. Meanwhile, Poland’s central bank left interest rates on hold at 0.10% on Wednesday and we think the window for a further rate cut has now passed. However, the central bank’s focus on supporting the recovery means that it will probably continue to intervene in the FX market and purchase government bonds to keep monetary conditions loose for some time. On Thursday, we think that Ukraine’s central bank will leave interest rates on hold at 6.00%. Most other analysts are expecting a rate hike, but we think that it will be a few months yet before inflation concerns prompt a tightening of monetary policy.

In the Middle East and North Africa, February’s batch of whole economy PMIs published on Wednesday showed that headline surveys in Saudi Arabia, the UAE, and Qatar all dipped last month on the back of tighter virus containment measures. Aside from the UAE, vaccination programmes are struggling to get going and restrictions will probably continue to weigh on domestic activity for some time. (Alex Holmes, William Jackson, Nicholas Farr, Liam Peach & James Swanston)

Published at 16.57 GMT 3rd March 2021.

Editor: John Higgins,

Enquiries: Jack France,