Crucial Question: Is It 1995 or 2007?
Before reading this week's update on the global macro and equities picture, investors are advised to add three new words to their financial dictionary:
- Endcyclitis - the fear that the global economic cycle is about to turn for the worse
- ABC - Anything But Cash; primal, though logical response to exceptionally low interest rates; can be a specific strategy, a portfolio positioning, a necessity for survival, or simply an attitude
- Market melt up - when equities embark on a relentless rally to the upside; opposite of a melt-down
With equity markets in the USA, and now also in Australia, near all-time highs and with bond markets signalling central banks will be cutting interest rates (further) in the year ahead, it has become fashionable again to be bearish on the world, the global outlook and medium term prospects for risk assets; or make that for all assets, since central bank policies post-GFC are often casually summarised as "bubbles everywhere".
The general view is that while lower interest rates and low bond yields temporarily push up the valuation of assets such as listed equities, the day of reckoning will soon emerge on the horizon because this economic cycle is getting older and weaker by the day, and soon investor optimism shall be replaced by the general realisation that economies are about to fall into recession, and corporate earnings will collapse.
There are enough surveys and anecdotal observations out there to suggest this is now the mainstream fear across financial markets, with the general advice to investors being: make sure you keep on dancing close to the emergency exit door, or else.
Even RBA Governor Philip Lowe weighed in on the subject last week describing the combination of weakening economies, central banks cutting cash rates and rising equities as a "strange world" he fails to understand.
History shows, however, equity investors' attitude thus far in 2019 is far from irrational and despite general scepticism whether equity markets can continue to post further, sustainable gains, there are precedents to show the current set-up need not end in tears.
Economic recessions are not an unavoidable certainty. It is equally plausible that Fed intervention, assisted by other central banks around the world, can keep this economic cycle going for longer.
If this proves to be the case, equity markets can potentially rise a lot higher, even after the stellar returns already booked since the beginning of the calendar year.
Investors' anxiety can be traced back to two main factors: the US bond market is inverted, with yields on longer dated Treasuries below those on short maturities, plus the apparent high-level stand-off between Washington and Beijing.
The first is seen as an early signal that the US economy might be awaiting its first recession since 2008/09. The second is another negative impacting upon economies worldwide; if no solution can be found it significantly increases the chances for a global economic recession.
No wonder, investors worldwide have become increasingly wary and anxious, positioning their portfolios cautiously and defensively. This has led to the rather unusual situation that Citi's proprietary Euphoria-Panic Indicator is signalling financial markets were in Panic mode at a time when equity indices had been posting new record highs.
Usually when record highs are being posted, investor sentiment surges into Euphoria, while Citi's Indicator into Panic mode traditionally happens near market bottoms. So who's correct? Whom should investors trust as the best guide for the year ahead?
Interestingly, Citi economists themselves weighed in on the rather awkward Indicator contradiction this week. And their advice?
Trust the Indicator.
A Panic reading means equity indices are most likely set up for further rallies over the coming twelve months. Upon reviewing the 44 instances in the past when a similar Panic reading combined with a fresh 52-weeks high, equities rose in nearly 98% of those periods looking out twelve months, Citi reported this week.
Of course, there are no guarantees and research conducted by economists elsewhere has shown a direct and close relationship between the economic path forward and what investors can expect from their investments in equity markets in the year(s) ahead.
It turns out the proposition is rather binary: if we do end up with an economic recession, share markets will sell off, at some point, and potentially end up a whole lot lower. Think 2007 and 2001.
If we do escape the recession scenario, there will be more gains, and potentially quite large sized gains in the year ahead.
Macquarie analysts recently conducted their own historic analysis and their observations confirm all of the above. In eight of eleven Fed easing cycles since 1971, US equities ended up more than 10% higher one year after the first cut.
The three exceptions are 1981, 2001 and 2007. The joint commonality in all three cases is the ultimate arrival of the feared economic recession.
The prospects for Australian equities could be even better. On Macquarie's research, the All Ordinaries tends to rise by 12% in the year after the first Fed rate cut. And this time around the RBA is cutting too.
If, however, the recession does arrive, both the S&P500 and the All Ordinaries tend to fall by -19% on average; and we all know the damage was a lot more in 2001 and in 2007.
History suggests the best sectors to hide in when a recession arrives are Food & Beverages, Paper & Packaging and Retail. Worst performers historically in Australia have been Steel, Diversified Financials and Technology Hardware.
Another interesting observation was put forward recently by the London-based European equities strategy team at Citi, not to be confused with their US peers mentioned earlier.
The team in London believes financial markets in 2019 are trying to mimic the set-up of 1995. That just happens to be the only year since 1989 when US equities, US government bonds, investment grade corporate bonds, high yielding corporate bonds and crude oil all returned at least 10% in the same year.
Back in 1995, the Fed cut rates in July. Back in 1995, US equities had already rallied circa 20% ahead of the first Fed cut. So far this year, gains for US equities are near 20% and markets have begun pricing in Fed rate cuts from July onwards.
For those who need reminding, with a few pull backs along the way, US equities rallied hard for several years until the Nasdaq bubble burst in March 2000.
The global context for income seeking investors was recently summarised as follows by asset strategists at JP Morgan Securities:
"10Y government bond yields continue to make new all-time lows in most G10 countries outside the US; Gold has made a six-year high and the S&P500 has made a new all-time high led by bond proxies like Utilities, Real Estate and Staples. The rally has been so broad across income assets that anyone targeting a 5% yield now has no alternative but to own cyclical assets like EM fixed income or US HY Credit and Leveraged Loans."
The quote above sums up perfectly why, all of a sudden, Australia's large cap bellwether stocks have landed back on investor radars. Even after the strong rally from the December low, National Australia Bank shares still offer 6%-plus yield.
I think it's probably fair to say this explains to a large extent as to why the ASX200 sits near the top of equity market performers in 2019, with only Russia, Nasdaq and S&P500 doing (slightly) better.
Total return for the ASX200, would you believe it, sits near 18% for the first six months of 2019 (capital return plus dividends).
Underneath the face value share market performance, however, still hides an extremely polarised field of winners and losers, and not just because Australian companies under pressure continue issuing profit warnings (or earnings disappointment in the case of Metcash on Monday).
With numerous sectors of the economy under severe pressure, and with technological and other disruptions continuing to expose weaknesses here and there, the challenge for investors remains not to fall for value traps; not in the least because many of the laggards are now seemingly offering above-average dividend yields. FNArena's Sentiment Indicator (see website) shows IOOF Holdings offering 9.67% and Michael Hill 9.62%, to name but two examples.
The all-important question to ask is: if a given stock has not participated in the strong market rally to date. What is the real reason?
Tony Brennan and James Wang, Australian market strategists at Citi, fully acknowledge it requires a leap of faith at this point in time, but they too believe the prospect of lower bond yields on the back of central banks cutting interest rates will provide support for the Australian share market.
No second guessing as to why both are positive on Australian banking shares in particular, as are many others - all for the same reason (see NAB above).
This is why Citi recently lifted its price targets for the ASX200 to 6800 by year-end (from 6700 prior) and to 7000 by mid-year 2020 (was 6850).
In summary: share markets have enjoyed the support of falling bond yields and a weakening US dollar, but they are likely to become more data-dependent in due course, which is likely to inject more volatility as corporate earnings and economic data, not to mention regional politics and geopolitical tensions will provide inconsistent messaging.
Despite general scepticism, investors should remind themselves no future outcome is as yet set in stone. Success from present policies is far from guaranteed, but the same applies for failure to keep an economic recession at bay.
The fact that financial markets are being dominated by "endcyclitis", and have been for a while, is no proof of anything. Last year the global majority sat positioned for rising interest rates and higher bond yields and look how that turned out.
Some experts have been toying with the idea of a market melt up into 2020. This must sound like heresy to those anticipating an economic recession later this year or next, but history is not without precedents. Imagine if investors decided to go all-in, ABC.
At this point it remains too early to decide which scenario looks most feasible. Probably best to keep an open mind, and eyes wide open.
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