Will the S&P 500 Extend Its Record Rally on Reflation Hopes?

S&P 500 FUNDAMENTALFORECAST: BULLISH

• A ‘Blue Wave’ outcome propelled hopes for more aggressive fiscal and infrastructure spending
• Weaker private jobs report painted a souring picture in the services sector
• The S&P 500 index is trading at 30.3 price-to-earnings (P/E) ratio, far above its 5-year average

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The exuberant rally in the S&P 500 index looks set to carry on as investors buy equity and other risk assets on reflation hopes – expectations that the Biden administration will be empowered to push forward fiscal and infrastructure spending after Democrats won two critical seats in Georgia’s Senate runoffs last week. In the meanwhile, base metal and crude oil prices surged to multi-month highs, reflecting a rising demand outlook as a cyclical recovery appears to be underway with the gradual rollout of Covid-19 vaccines.

Reflation refers to fiscal or monetary support that is introduced during economic downturns to spur growth and boost inflation, which usually occurs after an economic downturn. With the political chaos in Washington seems to be finally drawing to an end, investors appeared to have herded into stock markets chasing yield and growth.

Cyclical-linked energy, materials, financials and industrial sectors have been outperforming since the end of last year, extending a rotation into value from big tech names. The reflation trade may encourage a catch-up rally in the Dow Jones and S&P 500 index, both of which have largely underperformed relative to the Nasdaq 100 during 2020 as the pandemic hit traditional industries harder.

Source: Bloomberg

Yet, are market participants too optimistic about the economic outlook and pricing in a rosy picture of recovery too early? We are seeing a strange picture that is unprecedented – stock markets hit record highs when the global economy is suffering from a severe Covid-19 crisis that may last longer than people may have expected. A new strain of the virus and increasing lockdown measures may slow the pace of economic reopening, especially in smaller economies that lack the domestic market depth to cushion against external headwinds. The effectiveness of Covid-19 vaccines remains to be proven in the public, and an uneven rollout in different countries may undermine a global effort to contain the spread of the virus.

More worryingly, job market sentiment is weakening against the backdrop of pandemic waves and social distancing measures. In December, the US private payrolls report registered its first negative…