In the past few weeks, a puzzle has developed in the global financial markets. Equities, at least in the developed countries, have broken free of the constraints which normally bind them to fluctuations in the global economy. To misquote the old Heineken advert on British television, the central banks have refreshed the parts which other factors cannot reach. Inflection points in QE are all that seem to matter and there is barely an equity bear left in the investor community.
Of course, there are always a few exceptions which prove the rule. Albert Edwards, the markets’ favourite bear at Société Générale, wrote last week:
The intoxicating potency of QE has drugged investors into believing they must participate in this liquidity fuelled frenzy. I repeat my thoughts of 2007… this liquidity argument is merely “lies, rhubarb, poppycock, bilge and utter nonsense”…The unfolding recession accompanied by full-blown deflation will result in a loss of investor confidence so that central banks are unable to prevent a Japanese-style deflationary event. The equity market will riot, Japan-style.
Who knows, Albert’s bearishness may be justified in the very long run. But for now the bulls are in the ascendancy. The reach for yield is extending into the equity market, and it will probably continue to do so unless the latest mini downcycle in global activity develops into something more serious.
Since the 2008 crash, the stuttering global recovery has been characterised by several minor fluctuations in economic activity which have usually coincided with similar cycles in risk assets. The latest mini upswing peaked in January 2013, since when it has clearly moved downwards in almost all parts of the world, as shown by the Citigroup Economic Surprise Indicators in the graph below.
Furthermore, there has been a simultaneous decline in core inflation in both the US and the eurozone, which has already grabbed the attention of the central banks. One of the more surprising developments of the last week was the Fed’s explicit acknowledgment that it might adjust the pace of QE upwards as well as downwards in the future.
In my view, it would be surprising if core inflation were to drop much further, given the anchoring in inflation expectations which the central banks have achieved in the past decade (see this blog). But this cannot be taken entirely for granted. Economic activity indicators so far in 2013 Q2 suggest that global GDP growth may be around 2.5 per cent annualised, which is fractionally above the Q1 rate, but still about 0.5 per cent below trend. Business surveys are generally still moving slightly downwards, and the ratio of inventories to new orders suggests that manufacturing data are likely to weaken further in the next few months as excess stocks are reduced:
Given all this, risk assets might well have been expected to struggle recently, and indeed that has been the case in the commodity markets, where there have been sharp falls, especially in cyclically sensitive metal prices, like copper. Furthermore, bond yields have declined, and inflation expectations in the index linked markets have come down, as has been the case in previous mini down-cycles. But the surprise has been the robustness of equity markets, led by the US, where there has been a clear break in the normal relationship with other asset classes:
What has caused this break in the behaviour of equities? Three possible reasons spring to mind.
Explanation 1. The market might believe that the drop in global activity is clearly temporary. This seems possible. Consensus forecasts for GDP growth have not been downgraded since January, the maximum contractionary effect of US fiscal tightening will be over by mid year, and uncertainty risk premia relating to the eurozone crisis and the American fiscal cliff have obviously diminished sharply. The markets, learning from the previous springtime swoons in activity, may have decided to look through the “temporary” nature of the latest episode. But the trouble with this explanation is that it does not seem to apply to either bonds or commodities, so why has it applied only to equities?
Explanation 2. The drop in commodity prices is itself seen as a boost for world activity, and therefore for equities. Again, there may be some truth in this. To the extent that the decline in commodity prices is supply-driven, it should provide a useful boost to global growth in 2013 Q3 and Q4, thus offsetting the lingering impact of fiscal tightening. This would explain why commodities and equities are moving in opposite directions this time. But it is not clear that the decline in commodity prices is in fact supply driven. The slowdown in industrial activity, notably in China, is a more obvious explanation, and that stems from the demand side. This would not explain the divergent behaviour of equities and commodities.
Explanation 3. Global equities have followed government bonds and credit in joining the reach for yield. This explanation attributes the resilience of equities to the reach for yield which is occurring across the financial markets in response to ever-increasing doses of QE. These portfolio balance effects are a deliberate consequence of what the central banks are doing, not an unintended side effect of a strategy which is meant to work through other channels. Instead of boosting equities through the much-awaited “great rebalancing”, in which bond yields would rise as investors switch from over-valued fixed income into equities, investors are switching out of cash into those equities which have high dividend yields.
This is why defensive equity sectors, notably utilities, consumer staples, and health care are out-performing cyclical sectors, like energy, IT and materials, especially in the US. In other words, the sectoral pattern within the equity market is giving the clue about why the overall market is rising in the face of weak global economic data. It is just another symptom of the mega theme which is dominating all financial asset prices at the moment.
If true, this explanation would suggest that the equity bull run will suffer a major reversal only if the central banks change tack, or if the global economy gets dragged into a much more severe downturn than anything we have seen in recent mini cycles, in which case the dividend yield even on defensive equities may come to be seen as insecure. Even though the reach for yield is probably the dominant force at present, equities will be on fundamentally better ground when the current mini cycle in activity is consigned to history.