Bubble in stock market faces piercing inflation

Rise in PIB yield, Consumer Price Index point to higher inflation scenario

Faraz Ahmed March 15, 2021


A relentless rally in global equity markets came to a screeching halt lately as investors’ worst fears came true about stock valuations.

With rising coronavirus infection rates and mutation in the virus besides delays in the whole supply chain of vaccines, especially in the Third World countries, an uneven K-shape recovery can be expected at best.

Lately, the US indices were touching new highs as many stocks were trading at insanely high valuations eg Tesla Motors’ stock trading at price-to-earnings ratio of 1,000+ despite falling 30% from its peak.

Value investors are cautioning about the impending bubble in the tech sector, which may burst any time, taking down the whole US market due to its higher weightage.

The whole premise behind the illusion that this party in the stock market is not going to be over soon is mainly due to a very accommodative stance so far adopted by the central banks globally, which have inflated asset prices out of proportion.

The post-Covid retail-led rally globally is pointing towards excess liquidity and ease of access to markets with the rise of zero commission brokers in the US fuelling the irrational exuberance, which is the hallmark of any boom cycles in stock markets.

Just to get the perspective, the meteoric rise of GameStop stock 1000% north at the New York Stock Exchange, in total disregard to any fundamentals, by the so-called “Reddit Army” is mind-boggling and is being investigated by the Securities and Exchange Commission.

Despite JP Morgan’s recent disagreement with value investors about the presence of any bubbles, the risk of a sudden and sharp rise in inflation is looming larger than ever in the history.

With surging commodity prices since hitting the lows during the pandemic – West Texas Intermediate (WTI) crude at $69 per barrel (+280%), copper at $4.12 per pound (+200%), coal at $83 per ton (+68%), etc – the situation can spiral out of control faster than anticipated.

European Central Bank President Christine Lagarde cautioned last week that rising interest rates posed a risk to the broader financing conditions, forcing central bankers around the world to prematurely turn hawkish in their monetary stance.

Fault lines have already started to appear in stock markets with the recent sell-off in growth and tech stocks as the yield for 10-year US bond suddenly rose above 1.6%, causing widespread chaos in the interest rate-sensitive and overvalued tech sector.

The risk of rising volatility in western markets, especially in the US, has set off alarm bells across the globe since they are all interconnected in one way or the other.

Recently, China’s Banking and Insurance Regulatory Commission Chairman Guo Shuging warned reporters that there was a bubble in foreign financial assets, which may burst any time and can cause serious volatility in Chinese markets.

Back home, the relentless rally of the KSE-100 index post-Covid showed signs of exhaustion with the loss of 4,000 points (-8.5%) after hitting the 47K level, seen as a strong resistance that the market was not able to break above in April 2018.

The rally, mainly led by the construction sector and supported by exploration and production companies’ stocks, thanks to rising oil prices, is getting ahead of itself with the heightening political tensions.

Also, the circulation of news on social media about the withdrawal of tax exemption from mutual funds made investors jittery. A 42-basis-point rise in the cut-off yield on three-year Pakistan Investment Bonds (PIBs), auctioned recently, as well as the recent Consumer Price Index (CPI) data point to a higher inflation scenario.

Despite the forward guidance by the State Bank of Pakistan for a gradual transition, the situation can quickly spiral out of control due to supply disruptions in the commodity space and a sudden rise in pent-up demand post-Covid.

Although the stock market is not tech-savvy (read: heavy) or overvalued, the contagion of the sell-off abroad or strategy to book profit in the construction sector and rotation in the banking sector may intensify to mitigate the risk of rising interest rate.

The writer is a financial market enthusiast and attached to Pakistan’s stocks, commodities and emerging technology



Published in The Express Tribune, March 15th, 2021.

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