I don’t know about you, but I’m finding it increasingly hard to predict where markets will go next. I understand the logic behind the recent rise in equities – but not the certainty with which it’s being applied. We don’t know for sure what BREXIT or a Trump presidency means. So, I wondered…does this rally really signal confidence? Time to look under the hood…
It’s always perilous to attribute simple, single motives to market moves – but in this case the obvious answer to the recent spin in the markets is the best we have. The new dominant theme is the impact of the US election result and the shift in emphasis from monetary to fiscal stimulus. Market logic says that fiscal spending should increase growth and inflation, which is better news for stocks than for bonds. Bond prices fall and yield normally rise on the back of rising expectations for inflation, interest rates and rising levels of government debt – and the currency should strengthen according.
We’ve been talking about this theme for a while and oil’s gentle rally has also been boosting equities and inflation expectations for some time. What the Trump victory and subsequent pro-business, pro-fiscal stimulus rhetoric has done is solidify and provide impetus to the narrative – enough to convince investors to totally flip market dynamics in the US – the consequences of which have split out elsewhere.
This week brought a grand slam in US equity markets, with all four major indices hitting record highs. Meanwhile, European equities also haven’t been shy in moving forward. This is all despite only so-so earnings growth and what are still uncertain prospects for earnings. This rise has been at the expense of bonds, which have seen prices fall and yields rise across the developed world.
A simple rally? Not exactly – the devil is in the detail.
Picking the rally apart
Even in the US there is more nuance than the headlines suggest. The equity rally should arguably be tempered by a strong dollar and higher debt yields on earnings given the near-100% expectation for a December rate rise.
This isn’t a dominant theme, but it’s visible in the relative out performance of smaller company stocks that are less exposed to trade and dollar concerns. Larger technology companies on the opposite side of this equation have lagged. Financials have led the S&P 500 rally – aided by rising bonds yields and hints at regulatory change, although nothing is certain. Biotech stocks have benefited from cash repatriation hopes, but there’s no guarantee that this cash will find its way into US M&A – companies will be looking to see how the business environment pans out.
The situation in Europe is complicated by the fact it’s caught up in other countries narratives – with significant subplots of its own. There is an underlying tension between a stable to improving economic outlook in much of the region and growing political worries – from the upcoming Italian referendum to elections in France and Germany and the BREXIT fallout. Added to this now, it’s experiencing forces not entirely of its own economic making. The shift from bonds to equities is an effective monetary tightening for the region. Can the ECB or governments adjust their course to compensate?
The growing gap between rising Italian and German bond yields show that we can’t take yield movements at face value. Some increases are due to growth hopes, some are due to growth concerns and some yields remain low because investors still want havens – as in German short-term debt. Meanwhile, emerging market assets and currencies certainly aren’t feeling the love – as you’d expect when dollar and treasury yields rise. The post-election tantrum has subsided a little, but markets remain under pressure and emerging market banks are being forced to raise interest rates to defence their currencies. We could be testing contagion theories again.
In the UK, IPO markets highlight underlying caution
The UK is an interesting case. There is obviously a reflation-fiscal stimulus angle, which is driving gilt yields higher. Some equity prices have responded to the fall in sterling – for earnings and M&A prospects – others to the seemingly resilient performance of the economy thus far. Although, as the official forecasts highlighted on Wednesday, next year will bring a reality check in terms of growth and the negative inflationary impact of sterling’s fall.
This might not be reflected in prices, but it is reflected in the still lacklustre IPO market. There is a case for saying that fewer companies are coming to the market because there are more opportunities for funding elsewhere in this still low interest rate environment. But 2016’s fall has been too dramatic to be triggered by this alone. UK IPO levels are down by around a 50% compared with 2015 – and several potential listings have been pulled since the summer. What we hear from investors is that prices aren’t always factoring in the risks and uncertainties that lie ahead. Globally, there is a greater appetite, but – as we noted in our Q3 report – highlighted on Wednesdayuncertainty has subdued activity even when the background macro environment has looked more supportive. It will be interesting to see where we end the year and the prospects for 2017 in our next IPO report due in December.
Confident? Ask me in
Part of narrative has changed, but there is still a great deal of money in this QE world chasing returns. Previously it was arguably taking too rosy a view on debt markets, now may-be equities. But money has to go somewhere and there has been a tendency for investors to follow the herd in recent years. So perhaps this is more hope than confidence. It’s tough to say. The fact is that we’re still working through what BREXIT and a Trump government means.
We’re not totally in the dark. We know that the trend is from monetary to fiscal stimulus. This should have a stimulatory and inflationary impact. Companies are still looking to do deals for all the reasons we’ve discussed before. There are currency incentives in some markets – imperatives remain in some sectors. There are upsides to greater yields and inflation in developed markets. But, we shouldn’t under estimate complexity of the outlook. The recent Bank of America Merrill Lynch survey of fund managers highlights protectionism and monetary risk as their biggest concerns – but there’s probably plenty we haven’t thought of yet.
If 2016 has taught us anything it is to assume nothing.