July 16, 2019
Stocks are hitting fresh all-time highs as earnings estimates are coming down. Go figure. Investment houses like Morgan Stanley have turned bearish on stocks, taking their global equity rating to its lowest level in five years. Andrew Sheets, their Chief Cross-Asset Strategist, who looks all of 29, yet somehow holds court over all the house of Morgan, proclaims a recession with a steep correction looming.
That’s a bold call, considering the alternatives. Just for the record, when there are few places in the world to put vast amounts of institutional money – hundreds of billions of dollars seeking a positive return on bond yields, an economy with a strong pulse and a solid bid under the currency – why try to call a market top? Again, it’s a bold call and one they hope to generate fame and fortune from, but it’s probably early.
Quite frankly, the strong money flows into U.S. equities are an affirmation that the domestic economy is maintaining steady growth in light of slower growth around the globe. Most institutional money managers keep to themselves in edgy markets, preferring to stay nimble and not make vocal directional calls on the market. It’s a tough call to go on record to predict the future when there is no historical playbook by which the world’s most powerful central banks are operating in such a super-low-interest-rate environment.
Back in early December, the Fed raised the Fed Funds Rate by a quarter point and the market went into a hissy fit, correcting by nearly 20%. Since Christmas Eve, the Fed has “pivoted” and the S&P 500 has recovered by 28%. Last week, the Fed reinforced their commitment to sustain the economic expansion and the bull market has been elevated by a near-certain rate cut in two weeks. It is fascinating to see how global stock markets dictate to central banks to provide the stimulus it needs, on demand. We’re now well into a decade of global QE and investors have become highly accustomed to expect central bank stimulus to support a healthy stock market. Based on the latest narrative, this remains the playbook of choice.
The “Lost Decade” for Markets Outside the U.S.
Going back to the last full pre-recession year, 2007, it is remarkable to compare the performance of the S&P 500 against that of the Emerging Markets, Europe, China, and Japan. Emerging Markets and the European market are literally at the same level today as they were back in 2007. Investors in these markets have made no money in 12 years. Japan’s market has gained 27% during the past 12 years, averaging a compounded 2% per year. Investors long the Chinese market are down a whopping 50% from 2007 levels, while investors long the S&P are up roughly 150%, averaging a compounded 8% per year.
So, if all the quantitative easing of the past decade can’t get these foreign indexes off the mat, I’m not sure what will work for them, given where we are in the economic cycle. All the central bank’s efforts to restore inflation to a 2% rate have pretty much come up short, which makes the notion of deflationary forces that much more threatening in a global economic downturn, which Morgan Stanley sees coming.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
A rising fear of the world outside the U.S. entering a deflationary period is a big part of the reason why 25% of total global debt is sporting negative yields. By definition, negative interest rates incentivize banks to aggressively lend money, since they are being charged negative interest. But negative interest is also considered a last-ditch effort to boost economic growth when conventional fiscal policy tools fail.
So far, negative yields have yet to stimulate loan demand that spurs sufficient investment and spending to where the central banks can dial back their QE. This is a quandary that has foreign institutions hoarding money, willing to pay the bank to keep it safe while also pouring capital into U.S. Treasuries and equities.
To assume that this pattern of money flow is going to somehow come to an abrupt end doesn’t really add up, in my view. I believe that last week’s market surge is a testament that foreign capital is fast running out of patience and is in desperate need of being in strong dollar-denominated stock and bond assets for yield and total return. As long as this condition persists, the higher the U.S. stock market will likely go.