BUSINESS MAVERICK: Op-Ed
Recession: Now you see it, now you don’t
Investors are hungry for risk assets, comfortable that the risk of recession has receded. But do the economic fundamentals really justify the sharp rally in equities? Or are we going to see blood in the streets?
Cyclical and emerging market assets are on a tear on the back of dwindling expectations of a recession. But are investors betting too heavily on a Phase One US-China trade deal turning around the world’s growth fortunes? Or is there enough fundamental evidence to justify a more than 5% rally in key developed stock markets during the first half of the quarter?
Morgan Stanley chief investment officer Mike Wilson doesn’t think so. “We have continued to see weak economic and earnings data,” he says.
His model is predicting that US earnings are likely to come in at 0% next year versus consensus expectations of 10% – an enormous gap. Says Wilson:
“Investors are no longer pricing in slower growth, as our fund models are showing. Many stocks are now pricing in a fairly robust recovery.”
Economic recovery is by no means in view though. Last week in the US, there was further evidence of an economic slowdown, yet the Dow Jones Industrial Average ended the week breaking above 27,800, a new high and a significant resistance level.
Both US industrial production and retail trade statistics came in below expectations. Industrial production declined 0.8% month-on-month in October versus the -0.4% expected. Retail trade edged up 0.2%, half the expected 0.4% and Investec points out that the Atlanta Fed GDPNOW estimate for fourth-quarter growth is running at 0.3%, significantly lower than last week’s estimate of 1%.
Economic conditions in China and Japan remain a cause for concern too. In its third-quarter monetary policy report, the People’s Bank of China (PBOC) pointed to the “great difficulties” confronting the economy because of a complex external environment. It also noted that the PBOC would “increase counter-cyclical adjustment” to fight off the slowdown, which was displayed in disappointing industrial production and retail sales in October. Retail sales grew at their lowest nominal rate since 2003. Meanwhile, Japanese growth slowed sharply in the third quarter on the back of slowing export growth.
The only ray of light on the growth front last week was news that Germany had narrowly avoided dipping into a technical recession, managing to eke out 0.1% growth in the third quarter; still a cause for concern but not enough to be a mood dampener it seems.
From October 1 through to the middle of November, the DAX Index has rallied a hefty 9%, probably buoyed by the European Central Bank’s basket of monetary accommodation announced by outgoing ECB president Mario Draghi and the central bank’s last Monetary Policy meeting.
Investec Wealth and Investments chief investment strategist Chris Holdsworth says: “If history is any guide, we should expect a swift pick-up in European Union manufacturing shortly, given sentiment surveys.”
The latest Bank of America Merrill Lynch fund manager survey, which represents 230 managers managing $700-billion, highlighted the extent of the turnaround in institutional investor sentiment. Their allocation to equities, at the expense of cash, rose 20 percentage points to the highest level in a year. Fund managers canvassed in the survey are now a net 21% overweight in equities.
Emerging markets have been the beneficiaries of the sharp swing in appetite for risk-on assets. The MSCI Emerging Market Index has gained 6% since the beginning of October, with some commentators optimistic there is more to come as long as developed market interest rates remain at current lows.
But are there any economic fundamentals that justify the sharp rally in equities since early October and after a weak preceding few months? Optimism about the trade deal is certainly underpinning the recovery but that is concerning because it isn’t in the bag yet. Wilson thinks there is very little likelihood of a second and third phase before the US elections late next year, “so as much as possible needs to be thrown into the Phase One deal”.
Both the US and China are undoubtedly sufficiently motivated to get a deal done. China cannot afford further knocks to growth and Trump needs to secure a deal to boost his electoral prospects. However, last week again highlighted that it will be no mean feat to get a deal across the finishing line. Trump denies he agreed to roll back tariffs, contrary to an announcement by China, and China is reportedly dragging its feet on spending tens of billions on US agricultural goods. Failure to achieve these key components desired by the two parties would leave little else to cobble together a meaningful trade deal.
Both the US and China did make pacifying statements just before and over the weekend. US financial analyst Larry Kudlow calmed investor nerves by saying a trade deal was close and China said it had constructive discussions over the weekend.
In his column in the Wall Street Journal, headlined: “All News Is Good News When the Market Keeps Ripping Higher”, James Mackintosh questions what is behind the shift from “there is no alternative” (TINA), market-speak for the rally in equities prompted by the lack of potential returns offered by rock bottom bond yields earlier this year, to “there is an alternative” (TIAA) now that bond yields have increased. That hasn’t stopped the appetite for equities from increasing.
“Back then, a poor outlook meant lower bond yields, supporting the stock market,” remarks Mackintosh. “Now a better outlook means higher yields, but still supports the stock market. Who needs logic? Just buy.”
It is that kind of magical thinking that has ended with blood in the streets before, a term first used by Baron Rothschild in the 18th century. His statement in full, “The time to buy is when there’s blood in the streets”, could prove apt if fundamentals reassert themselves and those who are investing based on logic find themselves in a position to pick up the pieces from those who have not. BM