Global markets have been on a winning streak in March. Have they overshot to the upside or are they reacting to green shoots of improving economic data?
Last month, our focus was on what the markets were most worried about and how much fear was actually priced. We at the Global Investment Committee (GIC), Morgan Stanley’s group of seasoned investment professionals, concluded that while there was no shortage of concerns, the markets had likely fully discounted them and maybe even overshot to the downside. Since then, global equity and credit markets have come roaring back, with the most beaten-up assets rallying the most.
Of course, the question now is whether markets have overshot to the upside or if this is just a short-covering rally that will fade?
We at the GIC don’t think so, but we acknowledge elevated global uncertainty that leaves volatility high across most markets for the foreseeable future—a condition we have expected ever since the Federal Reserve began to normalize monetary policy in 2014 with the end of its Quantitative Easing program. Therefore, we should be prepared for setbacks, but we think most major equity markets have put in their 2016 lows.
Right now, we are at a point in which the data must improve for asset prices to continue rising or else we are likely to fall back into the trading range we have been stuck in for the past few years—or worse.
In the US, economic reports have been unequivocally on the upswing, led by better employment, industrial production and durable goods orders, as well as consumer income and consumer spending. We also continue to see a healthy housing market, with steadily increasing prices and low inventory.
Meanwhile, China has seen some stability in its economic data thanks to aggressive monetary and fiscal stimulus. At the same time, Europe and Japan have been weaker than expected as both suffer from political headwinds and fading confidence. These risks are likely to remain with us until the summer when the refugee crisis is likely to peak, Great Britain votes on whether to remain in the European Union (June) and Japan holds an important election (July).
So the global economic data paints a mixed picture. But the economy is not necessarily what drives or determines stock prices. Earnings matter the most—and earnings have been weak.
But oftentimes, the best market forecaster is the market itself. I’ve learned the hard way that one ignores the market’s message at his or her own peril. Since January, Mr. Market has been speaking loudly about a few things.
First, there has been a massive shift in market leadership. For seven years, growth stocks have outperformed value and the spread became excessively wide. This reversed sharply in the past month; rarely has value performed so well relative to growth in such a short period.
When this has happened in the past, it usually meant good things for equity markets overall and value continued to lead for the next six to 12 months. Fortunately, one of the changes we made in our latest tactical asset allocation changes was to increase our model allocations to US large-cap value stocks. Within the value cohort, sectors like energy, materials and industrials have been the strongest and now it looks like financials are joining in.
Meanwhile, other value-oriented but less cyclical sectors like utilities and consumer staples have begun to underperform, along with growth stocks. Even within the growth sectors of health care and technology, we are witnessing a rotation to the more value-oriented stocks rather than the high-flying, richly priced names.
So what does this mean? Typically, value stocks and sectors have tended to outperform when growth is on the cusp of accelerating. Since economic growth is stuck at low levels right now, could value stocks be telling us economic growth is about to inflect higher?
Given the magnitude of the moves we have seen, it would be foolish to ignore such signals. It will be critical to see how value stocks perform after some consolidation and retracement of the recent rally. If they continue to lead, it will be a good sign the data may improve from here.
Furthermore, we are seeing moves in nonequity markets that support an accelerating growth outlook as well. Credit spreads have tightened materially, commodities and other inflation measures like inflation breakeven rates and even gold have enjoyed their biggest simultaneous rallies in years as shown in the chart below.
These all suggest something more than short-covering by out-of-position traders. It is interesting to note that we have yet to see the kind of repositioning in many of these cyclical areas that we have seen during other false dawns like last fall’s. In short, investor sentiment remains skeptical and dubious. That’s a good thing.
Of course, we now need to see some accelerating growth or prices are likely to collapse, led by the same assets that led on the way up. Therefore, we will continue to monitor economic data as well as company earnings closely during the next days and weeks. We will remain invested and overweight global equities on the premise the economic reports are starting to improve and with the tea leaves positive, we think it makes sense to stay the course.