Samuel Potter, Ksenia Galouchko and Justina Lee
It was a heck of a week, considering nothing much happened.
US stocks just finished marginally higher for the past four days. The S&P 500 Index rose 0.6 per cent, having not closed up or down more than 18 points in any session. In fact, the so-called fear gauge for equities, the CBOE Volatility Index, posted the lowest average reading in the past four months.
That won’t ring many alarm bells for investors. After all, the S&P 500 has gained 16 per cent over the past nine weeks, so a pause is understandable. No cause for panic. Unfortunately, there are plenty of other reasons for that.
A menace was lurking in plain sight amid this sea of tranquillity: Growth fears have sent so many investors into the safety of Treasuries now with benchmark yields not far from the lowest in a year. The term premium has collapsed. Bond volatility is evaporating. And the bad economic omens have appeared by the day.
It raises a question: How long can this kind of stock performance survive?
“The rally definitely has meat on it, no way could it be resilient to that data otherwise,” said John Roe, the head of multi-asset funds at Legal & General with a combined £985 billion (Dh4.7 trillion or US$1.3 trillion) under management.
“What we’re now getting is Goldilocks being priced through 2019, with no Fed hikes, growth OK and recession risks fading.”
Yet a Goldilocks scenario requires economic growth to be neither too hot nor too cold. Given the speed at which expansion appears to be cooling, the resilience in equities seems remarkable. Sure, the bond rally is helping valuations and the hunt for yield for now — but the global data looks ugly.
German manufacturing shrank the most in six years, Japan’s factory sector contracted for the first time since 2016, and South Korean exports tumbled. Shares in the world’s biggest shipping line, a bellwether for trade, plunged on its downbeat outlook for the year.
Numbers in the US were hardly more impressive. Orders placed with US factories for business equipment unexpectedly fell in December, while there was a steep decline in business conditions in the February Philadelphia Fed Survey.
Despite this, retail investors are becoming more bullish on US equities. The share of mom-and-pop investors saying they’re bearish on US stocks in the weekly American Association of Individual Investors survey is near the lowest level since June, while positive sentiment is around the highest since November.
“It’s definitely the case there’s a divergence between the macro data and stock markets,” said Anna Stupnytska, head of global macro and investment strategy at Fidelity International, which manages about $379 billion of client assets. “The risk-on mood in the markets is becoming much sharper and more intriguing.”
It’s probably because for many investors the equation has now changed, thanks to the surprise pliability of Jerome Powell and his counterparts around the world.
The apparent capitulation of policymakers to the turmoil in markets seen late last year — at January’s rates decision the Fed chair acknowledged that “financial conditions matter” — means that bad news is now good news. Weak economic readings mean easier monetary policies and that keeps financial conditions loose.
“Central bankers repeatedly remind people that most expansions don’t die of old age, they are killed by aggressive monetary tightening,” said Brian Jacobsen, a senior investment strategist at Wells Fargo Asset Management, which oversees about $500 billion in assets. “If aggressive tightening is off the table, recession fears don’t have to become a recession reality.”
Because of this shift in outlook, an irony emerges: The growth fears that sparked the late-2018 sell-off are now a necessary part of the rebound. Should economic expansion get back on track, it would increase the chances of a Fed rate hike, tightening liquidity and potentially triggering more losses and volatility.
“We are starting to see a bit of complacency seep into markets,” said William Hobbs, chief investment officer at Barclays Investment Solutions in London. “Too much may be being made of the apparent change of direction from the world’s major central banks.”
Whichever is the bigger threat to the equity rally, higher rates or sliding growth, a consensus seems to be building that there may be limited upside following the recent epic rally.
For all that the bears are being contained, the bulls are hardly rampant. Investors are still not getting into the cheapest stocks, which tend to do well during economic booms, while growth shares are outperforming — signalling a willingness to pay more for growth because it’s scarce.
“The market is currently in a ‘glass-half-full’ mood,” said Michael Strobaek, global chief investment officer at Credit Suisse Group AG. “This optimism will soon require some fundamental support, either from the micro or the macro side. In the near term, we see the risks for equities as being skewed to the downside. We may have to wait for growth to improve to see renewed support.” The good news may be that any downside shocks may be limited. Roe at Legal & General said “it’s a bit worrying when bad data gets little response,” but it shows a lack of extreme positioning in the market and that means it’s not very vulnerable to bad news.
Ultimately, perhaps that balance of limited upside and capped downside risk may help explain this go-nowhere week.
“A lot of the good news has been priced in now and for equity markets from here to hold up and to make further gains, they’re going to need a trade deal to be done, for the Fed not to raise rates and for the global economy to continue growing over the next couple of years,” said Mike Bell, a global market strategist at JPMorgan Asset Management. “There’s a risk that at least one of these things doesn’t happen.”