OCBC OneWealth App– V for recoVery

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Global Markets

V for recoVery

26 April 2019

There and back again

The bloodletting in the fourth quarter of last year that led to a peak-to-trough loss of about 20% in 2018 has turned into one of the fastest recoveries in modern stock market history. In slightly over 3 months, the S&P 500 and Nasdaq Composite benchmarks have touched fresh all-time highs, while the Dow Jones Industrial average index is about 0.64% shy of its 2018-peak (as of 24 April 2019).

On a cumulative total return basis, regional markets have delivered positive returns as well. Europe and Japan remain the key laggards in comparison to the US and Asia ex-Japan, the latter two regions posting near 16% total returns in US Dollar terms. The market rebound has offered the kind of returns in four months that we typically see over a 12-month period in a very good year. A V-shaped recovery indeed.

Rise first, worry later

The recovery in market sentiment owes its genesis to three key factors:

1. Return of the central bank put

Fed policymakers, possibly spooked by the ugliness that unfurled in the stock market last year, did an abrupt about-face in monetary policy.

In December last year, they were unreservedly hawkish, unyielding in their view that the economy was on sound footing and could withstand a few more rate increases. A few weeks later, policymakers sounded decidedly cautious, eliminating the prospect of further rate hikes in 2018, choosing instead to stay patient.

Admittedly, nothing of economic import had changed in the interim. Of course, stock markets were battered, and financial conditions were tight, yet economic fundamentals did not show signs of meaningful deterioration. One would think that floundering stock markets and tighter financial market conditions would be the organic consequence of policy tightening and therefore expect the Federal Reserve to remain unperturbed and pursue their chosen rate hike trajectory.

Alas, one would be mistaken. Backed away the Fed did, their stance predicated on a weaker inflation outlook and slowing global growth. It was not long before other central banks, including the European Central Bank and the Bank of England followed suit, choosing to err on the side of caution amid a more precarious growth outlook.

The growing flock of policy doves echoing the tune of caution in almost perfect unison was a siren song for most investors to plough back their fortunes into the stock market. There was little reason not to, not when the central bank put was back in fashion.

2. Hopes of a US-China trade deal

The fears of a prolonged and ugly tariff war between the two largest economies in the world – the US and China – was one of the many reasons for the sell-off in stock markets last year.

A truce was called, and a long negotiation process followed. There was scepticism at first, but that gave way to optimism as signs of progress emerged, played up to great effect by financial trade journals, the Chinese state media as well as President Trump’s twitter account.

Four months on and a deal has yet to be finalised. But they are close, we’re often told. There are some sticking points, but they’ll iron it out. Don’t worry your little heads about it. And judging by the recent market rebound, investors certainly haven’t. The prospect of a resolution was enough to reassure the market. Hope floats after all.

3. A low base

The rally in the first quarter this year has largely been driven by price-to-earnings multiple expansion as investors swooped in to buy stocks that were oversold and trading at attractive valuations. This in part explains the broad rally seen even among companies that reported weaker-than-expected earnings during the 4Q2018 earnings season.

The upshot is a market that appears more expensive now than the preceding quarter, with most major markets trading at price-to-earnings valuations above their past 7-year average. At 16 times, the MSCI US index is trading about 0.6 standard deviations above the 12-month blended forward price-to-earnings past seven-year average. Asia ex-Japan stocks are not cheap as well, with the index trading close to 2 standard deviations above its seven-year average. On this basis, European and Japanese stocks appear more attractive.

Rocky road to hell or smooth sailing to nirvana?

It’s tempting to think that markets may be able to continue their ascent with nary a concern in the succeeding months. From the outset, it’s not 2017: We’re not operating in a macro landscape where growth is broad-based and robust. Neither are we in a terrain that is unmarked by uncertainties in the political environment. For the rally to sustain, investors would need to gain clarity on a few fronts:

1. Stability or rebound – both are acceptable

The general trend has been a persistent downgrade in 2019 growth forecasts by an alphabet soup of supranational agencies including the OECD, IMF and various central banks.

Downward revisions for Eurozone growth were especially salient as the region continues to work through certain transient (hopefully) and idiosyncratic factors that had pressured economic activity in key countries such as Germany, Italy and France. As it stands, economic data has been mixed, and a possible interpretation could be that the path to stability remains paved with challenges.

China was a pressing concern in 2018 as well, its economy working through intense deleveraging and confronting, at the same time, an adversarial US administration on trade. Stimulus efforts are well underway in the country and green shoots in recent hard and soft data point to some degree of stabilisation in the economy.

On a global scale, central bankers have heeded the call for support amidst a slowing global growth backdrop and tepid inflation outlook. The dovish tilt of recent monetary policy should support growth in the second half of the year (as monetary policy works with a lag).

The “shoulda, coulda, woulda” trinity of non-definitive commentary might be reassuring for the time being. And indeed, markets have priced in expectations of growth stability. But this also means that they are susceptible to corrections should disappointments arise, especially in data coming from systemically important economies including Europe and China. In this, we remain watchful.

2. The courtship must end with consummation

The US and China have pranced around the prospect of a deal for many weeks without so much as a draft in sight. Recent disagreements have centred on the issue of establishing monitoring and enforcement mechanisms, with China balking at the seeming one-sidedness of the US’ proposal.

With the Chinese economy showing nascent signs of stabilisation, China faces less pressure to strike a quick deal. An improving economic outlook could give them the chutzpah to push back on US demands of verification and the right to exercise unilateral punitive actions.

In substance, the resulting deal might just be a ceasefire agreement than a peace treaty. The roll-back of existing tariffs may be more a dream than a realistic expectation. Nevertheless, a deal would remove a key uncertainty from the mix.

But what President Trump gives with one hand, he takes back with the other. Tensions with China may cease temporarily, but other tensions are already brewing. The EU and Japan and the automobile sector are the possible new targets for President Trump’s protectionist proclivities.

Should he act on these urges, even if such actions were justified, the growth outlook and market sentiment could suffer. Again, we remain watchful.

3. Show me the money

Coming off the sharp market rebound, the “show me the money” factor becomes particularly crucial to sustain this rally. A rebound in earnings and improvements in operating margins will be key to keep this rally alive amid increasingly rich valuations. A higher base could set markets up for disappointments.

Where do we stand when all is said and done?

With markets hitting 2018-highs, we have become more circumspect about the potential for a sustained rally. Sure, markets were oversold last year, and the recent rally may be the result of investors correcting the mess of their overreaction. But after a four-month sprint, we need to see evidence of a recovery in the growth outlook.

We are by no means bearish. We are by most measures cautious. There is a difference. Along this line, we would choose not to add risk aggressively to portfolios as we await clarity on the outlook. Like the Fed, we need to be data dependent. And while the economic data provides some evidence of stabilisation and potential green shoots, it has not provided a firm enough reason to be unabashedly exuberant.

After a near 16% rise in markets, let’s take a step back and enjoy the view. How bad can that be?

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