With 70+ trading days left, markets head toward year-end with solid growth, low volatility and tepid inflation. So why aren’t investors giddy with optimism?
For all of the market’s fancy quantitative models, it still remains driven by an agrarian calendar. Summer vacation months, which were once planned around the harvest, lead to a lot of ‘out of office’ replies and slower activity. And then, as the calendar flips to September, we all return, hopefully well-rested, with 70+ trading days left in the year.
This year, the backdrop that investors return to is a constructive one through year-end. Global GDP and earnings per share (EPS) growth remain solid, the strongest since the last quarter of 2010. Financial conditions remain exceptionally easy, helped by softness in inflation. And measures of corporate and investor sentiment, while not fearful, remain far from exuberant.
The problem with good growth is that it means tighter policy. But softness in core inflation provides central banks with a window to keep policy relatively accommodative.
Recently, I was speaking with investors at the Morgan Stanley Global Macro and Strategy Day in Frankfurt and heard some pushback to this optimistic view, specifically on two issues: (1) expensive equities valuations and (2) near-term risk events such as tensions in the Korea Peninsula, the U.S. debt ceiling, and Brexit negotiations.
Let me first address the positives: Global growth looks solid. Morgan Stanley economists believe that real global growth rose above 4% in the second quarter, the strongest reading since 2010, and one that comes with impressive breadth. Purchasing Managers' Indices (PMIs) are above 50 in the U.S., eurozone, China, Japan and Brazil. New highs in Korean export volumes and commodity price strength would seem to confirm this story. And this growth is passing through into earnings, where we estimate double-digit 2017 EPS growth across all major equity regions.
The problem with good growth, ironically, is that it often means tighter policy. But softness in core inflation, a trend our economists expect through year-end, is providing central banks with a window to keep policy relatively accommodative. This won’t last forever, and our forecasts predict a pretty material pick-up in inflation in the G3 economies (U.S, eurozone and Japan) beginning around March 2018. But for now, we have solid global growth and some of the easiest financial conditions in history.
Solid growth and easy policy wouldn’t matter if investors were already giddy with optimism. But I’d venture that they aren’t. My colleagues in prime brokerage tell me that net hedge fund positioning, globally, is near the long-run average. Investors have pulled money out of U.S. equities over the last 12 months, which is hardly a sign of euphoria. Meanwhile, corporates aren’t yet doing the things that indicate an outsized level of greed and hubris: capital expenditures remain muted, and trailing 12-month M&A activity is less than half of where it peaked in 2000 or 2007.
That’s fine, but don’t current volatility levels scream complacency? Maybe. But it’s important to acknowledge that, as low as implied volatility is, it has rarely been higher relative to what’s being realized by the market. To get realized volatility sustainably higher, it may take 1) less predictable central bank policy, 2) higher asset correlations, 3) weaker growth and 4) more aggressive corporate activity. We are not seeing these yet.
So what about valuations? I don’t come into the office every morning excited by the prospect of recommending expensive securities to clients. Quite the opposite. But we also have to acknowledge that markets are spending a decent amount of time (indeed, about half the time) more expensive than average. And if one had to construct a scenario where above-average valuations would be supported, “solid growth, cheap money and below-average volatility” would seem like a reasonable place to start. These won’t last forever, but we do think they persist through year-end.
It is also not quite accurate, in our view, to say everything is expensive. The euro, Malaysian Ringgit and Mexican peso—all currencies we like—still trade well below average on purchasing power parity (PPP), which compares the cost of similar goods across countries. Our emerging markets strategists see value in the local rates of Mexico (10yr @ 6.8%), Indonesia (2yr @ 6.0%), India (5yr @ 6.5%) and Turkey (5yr @ 10.7%). Even the multiple for global equities (forward price-to-earnings ratio of 15.9x) is right in line with the 20-year average, and broadly unchanged since July 2016. At the same time, there are ‘expensive’ things we dislike, including U.S. credit, 1y1y Euro OverNight Index Average (EONIA) and the Swiss Franc.
Then there is the issue of near-term risks. Tensions are high on the Korean Peninsula. Confidence in the U.S. administration keeps falling. The UK faces difficult Brexit negotiations. The Federal Reserve Bank and European Central Bank (ECB) have key meetings in the next two months. Finally, September is often a weak month for returns.
All of these concerns are valid but, in our view, surmountable. My colleagues Deyi Tan and Jonathan Garner note that measures of Korea-specific risk (equity volatility, rate volatility, sovereign credit default swaps) aren’t particularly elevated, which makes hedges affordable but also doesn’t square with the most concerning scenarios for global investors. A recent deal to increase the U.S. debt ceiling likely pushes back a risk that had worried us greatly. We think that the risk of bad Brexit headlines will be contained to the UK, and most likely to show up as GBP weakness.
As for central banks, we expect the Fed to announce balance sheet reduction at this month’s meeting, and the ECB to announce tapering next month. We think those shifts are expected (and thus manageable), but that it is also inexpensive to hedge a scenario where markets price in more hawkish policy, as our rates strategists think 1y1y EONIA is too low at -0.30%.