We last wrote about equity markets in the summer and ‘called’ the top. Our point was not that equity markets were about to crash, but that the authorities were starting to withdraw liquidity from the market, and that economic growth was already starting to decline after the COVID-19 recovery pop. With inflation picking up, we thought there was much more downside than upside in equities.
Five months later, it is clear that there isn’t much growth in the world. Japan’s latest quarterly number was negative, China and Europe’s only just positive, and the U.S. preliminary figure was only 2% annualised. We see this as largely a consequence of monetary policy, while still ‘loose’, being significantly tighter than the previous 18 months.
At the same time inflation has taken off, and at 6.2% in the U.S. is now the highest for 30 years. We wrote an article about this too in the summer. Our view was that this was largely caused by supply-side factors such as the rise in energy price and trade frictions. While not wishing to be complacent, we doubted this was the start of a sustained rise in inflation. For what it’s worth, we think the Bank of England was right not to raise rates.
Despite moderate economic growth and higher than comfortable inflation, the U.S. equity markets have carried on motoring upwards, followed by Europe. The Chinese market has been weighed down by the travails in the real estate such as Evergrande, and Japan has gone sideways. Generally, however, equity markets have chosen to ignore the macro-economic fundamentals.
Of course, there are explanations. The global equity indices are dominated by the U.S., now nearly 70% of the developed market, and these are dominated by a small number of mainly consumer tech companies (e.g. the top 9 now represent nearly 20% of the whole world’s markets). They have by and large continued to hoover up market share and deliver earnings growth. At the same time, the falls in bond yields have provided valuation support.
So, what happens next? The end October liquidity data from our friends at CrossBorder Capital suggest that monetary policy is at 71 (range 0-100). However, while most of the world’s central banks are at about neutral and some (Bank of England, Central Bank of Australia) tighter, the Federal Reserve is appreciably looser. The cynic would suggest that Powell is under pressure from a more dovish administration.
Bond markets are not encouraging. They are pricing in rate hikes at the short end, credit problems in the medium term and lower inflation at the longer end. Are they expecting a policy error where central banks over-tighten, and the result is some form of recession followed by disinflation? We think that fits with two major themes of ours which we have regularly drawn to readers’ attention.
First, the People’s Bank of China’s actions are more important to the world than the Federal Reserve’s because they are now the world’s manufacturing centre and importantly trade with the rest of the world more. China appears to be happy with a lower level of economic growth than the past 30 years and has no incentive to rescue western financial markets. We think their focus is more on economic stability than all-out growth now, and they will only ease policy in a moderate manner.
And secondly, the financial system remains highly fragile because of its dependence on refinancing and the repo markets in particular. The consequence is that western central banks will respond to future financial crises by further bouts of quantitative easing.
If we are right, and the background is one of low or even negative economic growth, inflation slowly subsiding, accommodative policy in the West but not the East, where does that leave bond and equity markets? We think it points to bond yields remaining very low. Central bank supply of government bonds may remain plentiful, but will be soaked up by demand for repo and refinancing collateral. At a policy level, disinflation and the potential for policy errors will – a bit like Japan in the 1990s - reinforce the bond yield curve generally remaining at very low levels.
Equity markets may continue to be resilient at index level, simply because of the onward march of ‘tech’ and the way the global indices are dominated by the U.S. Valuations today are expensive compared to history but not unreasonably so. We are also aware there is a mountain of dry powder in private equity which is being directed at some of the residual ‘value’ parts of the market.
On the other hand, a combination of low economic growth and either stubbornly high (if we are wrong) inflation, or alternatively disinflation, does not sound like a good recipe for equities. That is why, despite the Wile E Coyote*-like antics of markets today, we continue to believe that there is far more downside in equities than upside. While the fundaments, macro- and micro-, are steadily worsening, it is not happening yet in a dramatic enough way to upset markets. Of course, if central banks do indulge in a policy error by raising interest rates too quickly, that could be the catalyst for a plunge into the canyon.
* If you are under about 60, see Looney Tunes’ Road Runner cartoons 1948 to 1964