With the bulls routed so far this year, what are the biggest concerns driving market pessimism right now? A global slowdown, China, dollar strength, weak oil, geopolitical uncertainty in the US, UK and EU, just to name a few…
It’s hard to remember many occasions when investor sentiment has been quite as bearish and widespread as it seems today. Sure, 2008 was worse, as the global financial crisis and fears of global depression created panic in markets. But today’s cool disdain for risk assets still takes some beating.
When asked this week what reason bullish investors were citing for their optimism, I had to confess that I hadn’t met any recently. The collective noun for a group of bears is a “sleuth,” but it doesn’t take much detective work to identify what investors are concerned about. Moderating growth expectations are likely one reason for this more cautious approach, although it’s hard to argue that the macro data actually show a step-change down.
From this vantage point, current concerns reflect a rising probability of a “bear case” outcome as much as, if not more than, a more muted “base case.” The most plausible bear-case outcome, aside from general economic recession, contains a mix of China policy concerns (especially on currencies), US dollar strength, falling commodity prices, poor emerging market newsflow and asset performance, and geopolitical uncertainty, including the US presidential election and the expected UK referendum on whether it will stay in the European Union.
A number of these attributes have featured highly in market newsflow in recent weeks. The sharp falls seen in risk assets are now starting to prompt a central-bank response that, when combined with low investor sentiment, does increase the potential for two-way (as opposed to one-way) volatility in markets. However, absent an improvement in fundamental newsflow, any relief rallies could prove short-lived, as investors increasingly question the value and effectiveness of further central-bank action.
In this respect, the growing perception that central banks are moving away from quantitative-easing-style programs to negative interest rates seems less supportive for equities. With little evidence so far that negative rates can boost aggregate economic activity, the risk is that this policy tool increasingly resembles a more blatant form of “beggar thy neighbor” currency devaluation. A shift toward a more nationalistic and perhaps less coordinated global policy response could signal a quickening in the pace of fiat currency debasement and augurs badly for risk appetite.
Part of the positive thesis on developed-market equities in recent years had been predicated on their attractive valuation relative to other asset classes. However, in periods of heightened uncertainty, relative valuations provide investors with much less solace, and absolute valuations tend to take over.
On this basis, it’s hard to argue that equities are cheap enough to trough on valuation grounds alone, given that MSCI World’s trailing price-to-earnings, price-to-book-value and dividend yield ratios are only around 0.5 standard deviation below their 30-year averages and the trailing price-to-earnings ratio for the global median stock is exactly in line with its long-run average of 20.5.
One noteworthy aspect in the current risk-off environment: the lack of peripheral spread widening in Europe, which is unusual based on performance patterns during this cycle, and most likely reflects the European Central Bank’s substantial QE program. While equity investors often perceive the region as a relative consensus overweight, we at Morgan Stanley Research are more downbeat and prefer the US and Japan. Our European caution primarily reflects the prospect of further earnings disappointment across the region, but we are also wary of any resumption of geopolitical concerns.
Recent investor caution tends to focus on fears of excess dollar strength, low oil prices and/or China, but it is quite plausible that Europe moves back up the pecking order (to its more usual place some would say!) as we move through 2016. The UK’s forthcoming referendum on EU membership, likely to take place in June, may appear the most plausible catalyst in the short term to raise regional risk premia, but the ongoing migrant issue risks eroding political cohesion over the medium term and political uncertainty is rising on the horizon.
Other EU worries: Greece has a daunting debt repayment due this summer; Spain is currently without a government; new European regulations are preventing Italy from adopting an effective “bad bank” solution; and the recently elected socialist government in Portugal is reversing course on prior austerity and competitiveness improvements. During a cyclical upswing, markets are prone to overlook such concerns, but the opposite would be true if growth starts to relapse.
For now, productivity remains harder to come by than our young protagonist’s climbing of the Jedi ladder. What is reassuring, however, is that both will eventually win.