Financial markets have certainly taken the globe on a wild ride in 2015.
After a strong start at the beginning of the year, the summer has been increasingly volatile, starting with the threat of Greece’s exit from the euro and ending with Chinese policymakers losing control of their managed economy and capital markets. Still, the reality is that the trajectory of economic and earnings growth hasn’t changed much in the past six months. In fact, the data suggests growth might actually be stabilizing and even accelerating.
For instance, US second-quarter GDP came in at 3.7%, which is well above the 2.1% average since the recovery began in 2009 and much stronger than the 0.6% achieved in 2015’s first quarter. Based on recent data and trends, the third quarter should also be well above the average of the past several years. Meanwhile, 12-month forward earnings estimates for the S&P 500 have been steadily increasing since February and have recouped almost all of the sharp reductions we saw at the end of last year emanating from lower oil prices and a stronger US dollar. Finally, economic data and earnings growth have also been improving in other developed countries such as Europe and Japan.
So, if growth is generally stable—albeit at a low level—and valuations appear attractive relative to bonds, why all the concern from equity investors? And why are we seeing such extreme volatility?
Global growth uncertainties
Morgan Stanley Wealth Management's Global Investment Committee (GIC), a group of seasoned investment professionals who meet regularly to discuss global economy and markets, has no doubt that much of this concern is centered on China and the sustainability of global growth. However, our analysis suggests these worries are overblown.
China’s growth is definitely decelerating, and has been for years. The GIC fully acknowledges this slowdown and we do not think the Chinese economy is ever going back to its rapid growth rates of the past 20 years. However, we don’t think it’s going to collapse, either, and most of the negative impact has already been discounted by the markets most affected.
For example, witness the 50%-plus collapse in most commodities and equities that are highly leveraged to Chinese manufacturing and fixed investment. Conversely, notice how well many global consumer, health care and technology companies continue to do in this new world order in which services are outpacing manufacturing. Furthermore, this is not just a China phenomenon, but a global one. The bottom line is that growth is slow, but not negative. Understanding the mix is important. This is why we remain constructive on sectors like consumer, health care, technology and even financials, which usually benefit from the credit growth that typically follows a rise in consumer confidence.
The other cited concern from equity investors is that stocks are expensive. However, the equity risk premium for the S&P 500—the excess return the S&P provides over the risk-free rate—is more than four percentage points; the long-term average is just 1.3 percentage points. In 1987 and 2000, the premium was extremely negative, leaving no doubt stocks were expensive. Relative to those time periods, US stocks are exceedingly cheap. European and Japanese equities are even cheaper on this metric.
So, again the question: If growth is generally stable and valuations appear attractive, why the extreme volatility?
Quantitative tightening?
The GIC thinks it has to do primarily with tightening financial conditions. When the Fed ended its Quantitative Easing (QE) program last year, we suggested this was akin to the first rate hike of this cycle. Many pundits still disagree with this view and remain overly preoccupied with the Fed’s increase in the federal fund rates as they have done in previous cycles. However, we think the end of QE led to a significant tightening last year. This is one reason why higher beta stocks and higher beta equity markets like Europe and Japan did poorly last year. These financial conditions improved significantly earlier this year after the Bank of Japan increased its QE program and the European Central Bank launched one. These efforts effectively offset the Fed’s exit from QE.
All was going well until China’s stock market crashed 35% this summer. China’s policymakers decide to use the country’s massive foreign reserves to try to stabilize it. Next, they devalued their currency in August, and used more reserves to make it orderly. This diverted a significant source of liquidity away from global markets, effectively tightening financial conditions.
One could call it a “quantitative tightening” that has essentially trumped the improving fundamentals. The GIC believes equity markets will have a hard time recovering their recent losses until these financial conditions improve. We think this will happen through a combination of better growth and more monetary and fiscal stimulus in China. However, that could take another two to four weeks. The good news is that financial conditions have already improved a little and the index is now below its recent peak. The GIC needs to see more improvement and will be monitoring it closely.
