Financial markets looking for a second wind
Financial markets search for a second wind
Equity markets in developed economies rebounded in February, after spending December and January in an attitude of crisis. We think that this is just a tactical rebound, rather than a return to the bull market that prevailed on equity markets from 2009 to 2014. The fundamentals that limit the upside for equities have not changed; meanwhile, the limits of central bank policy are becoming increasingly apparent.
Sell-offs on financial markets in December and January were prompted by fears over the impact of lower oil prices and negative interest rates. The implementation of negative interest rates by the Bank of Japan (BoJ) and the European Central Bank (ECB), designed to reflate asset prices and boost economic growth, had quite the opposite result. It rekindled deflationary fears through a potential shock to banks’ profitability, which threatened the credit cycle. As we had feared, the monetary policies currently pursued by the main central banks appear to be weakening in effectiveness – or even seeing their impact reverse. This explains why markets periodically switch to a ‘risk off’ mode.
However, economic fundamentals remain reasonably healthy, albeit lacking in momentum – as expected in our core scenario. The US is on course for real GDP growth of 2.0% this year, and the euro area for a slight acceleration to growth of 1.8%, supported in both cases by robust domestic demand. China remains on track for GDP growth of 6.5%. This explains why markets periodically switch back to a ‘risk on’ mode.
At the same time, earnings growth expectations continue to be downgraded for both US and European blue chips – to just 2.6% for the S&P 500 composite and 3.3% for the Stoxx Europe 600, territory more commonly associated with recession. Energy is the main contributor, but other sectors are also suffering, in part because of spillover from the energy sector. This limits the potential upside for equities, and means a new bull market is not currently in prospect.
Against this background of a lack of momentum in economic growth and earnings growth, and waning effectiveness of monetary policy in supporting financial markets, we ideally need a strong new policy mix, including a fiscal component, international co-operation and a new monetary-policy style. This would dispel deflationary pressures in the developed world, address the risks to the credit cycle, and justify strategically overweighting equities. But there is no sign of this as yet – for instance, the G20 meeting in Shanghai in February failed to produce anything of substance.
Other possibilities include ‘helicopter money’ (direct crediting of personal accounts for consumption by central banks), an idea that is gaining ground. Such a policy move would favour introducing gold into the asset allocation.
In the absence of these fundamental changes, rebounds on equity markets are still possible, as at present, but are likely to prove weak and short-lived. In the short term, the measures already heralded by the ECB and expected on 10 March will be key. The current market rebound probably has a short way still to run.
We therefore retain our tactical overweight on equities for the present. A tactical asset allocation and stock-picking remains the best approach, given our expectation of continued high volatility and low returns on asset classes.