Market Outlook: Less Macro, More Micro

In the past year, a staggering number of high-profile stories related to macroeconomic risks have grabbed headlines and driven market volatility. They include a surprise devaluation of the Chinese yuan, worries of waning central bank potency, weakness in oil and the industrial sector and, most recently, the unexpected vote for Brexit.

Recent market highs suggest the effects of such risks may be contained. By their nature, macro events are difficult to predict, but the current outlook is decidedly calmer than in the past year. Given this, are markets now poised to trade less on headline fears and more on fundamentals?

To answer this, we at Morgan Stanley Wealth Management developed a means to measure the extent to which macro risks have driven stock returns in this recent, turbulent period. To do so, we selected four key assets whose price action has been most closely related to recent macro fears.

First is the U.S. dollar, the excess strengthening of which had triggered fears of declining global liquidity, slowing U.S. exporter sales, and risk-off sentiment.

Second is oil, which plummeted across the second half of 2015 and first half of 2016, raising fears of declining global growth and suggesting potential stress among energy companies, oil-producing emerging market nations and lenders to these institutions.

Third is gold, where rising prices have historically coincided with a compromised growth and inflation outlook and heightening risk aversion.

Fourth and finally is the two-year U.S. Treasury, where higher yields have coincided with fears of excessively hawkish, potentially destabilizing Fed policy paths. Having identified these assets as a proxy for macro fears, we examine them in conjunction with the equity market (see chart below). We expect fear-driven markets to display a stronger correlation to these assets; on the other hand, in periods in which equities trade more independently from these assets, opportunistic risk-taking can overcome such fears, placing greater emphasis on company-specific merits.

During these periods, we would expect fundamentals to play a larger role, allowing companies representing more compelling values to outperform.

Macro Factors Are Having Less Impact on Equities

Were markets in the period leading up to the Brexit vote driven largely by risk aversion, as the many fear-inducing headlines would suggest? Our analysis says yes, as the correlations between both domestic and global equity returns were higher than the average over the course of the cycle. This is consistent with the news flow—both at the beginning of the year when the higher dollar, lower oil, and doubts around the December 2015 Federal Reserve interest rate hike combined to provoke the market sell-off, and at the end of June right after the uncertainty provoked by the Brexit vote. As these concerns peaked, markets appeared more driven by fear.

What does that analysis reveal about the current landscape? Since the Brexit vote, the story has been very different. As of the end of August, equity returns have decoupled materially from these risk assets, with correlations to macro, fear related assets now sitting below cycle averages. Despite this post-Brexit period comprising only two months, we are encouraged. This message from financial markets seems to reflect the seeming lack of headlines related to potential market perils. Consequently, the diminishing role of fears means stronger fundamentals could play a larger role going forward.

This could help risk assets. Though there is widespread skepticism around equity markets continuing higher, we see the global expansion remaining intact and adding strength to the earnings picture.

Further, for those investing through active managers who carefully study company fundamentals, greater focus by markets could result in enhanced returns through more effective stock-picking.