- In the closing months of 2016, it’s important to analyze the forces driving the recent market rally and how trends might begin to move in different directions.
- Politics and economic momentum provide reasons to be cautious regarding risk assets, but policy remains supportive.
- The debate surrounding “safe” stocks is less empirically grounded than many think, though it is right to question general equity market valuations.
The summer relief rally has run its courseTo set portfolio strategy through the end of the year, it’s important to consider what fueled the unexpected rapid market rebound during the summer. The rally in risk assets that began on June 28 was driven to varying degrees by three specific forces. The first was the possibility that, after Brexit, political risk no longer mattered to markets. But there is another way to interpret this. The speed with which global equities clawed back their initial losses following the Brexit shock was aided to some degree by Spanish voters rejecting the anti-austerity (and thus anti-EU) Podemos party in their election on June 26.
Second, markets were also flattered by the notion that the world’s major central banks were going to continue providing additional monetary stimulus. The Bank of England eased immediately following the Brexit vote, but it was widely believed that both the European Central Bank (ECB) and Bank of Japan (BoJ) would either extend the duration or expand the size of their asset purchase programs into the second half of the year.
Third, there was a reversal in the general sense of unease about the trajectory of developed market macroeconomic health. Higher frequency economic data had been surprising on the downside across developed markets, and the May employment report in the United States called into question the sustainability of the labor market recovery. Then, the release of June U.S. payrolls data on July 8 reversed those concerns with a strong headline number, breaking what appeared to be a weakening in the trend for the year as a whole. Thus began a period of “risk on.”
Political trends signal caution
Much changed in September, and we are starting to see cracks in the foundations of the summer rally. The U.S. presidential race has tightened substantially, adding a new source of uncertainty. Elsewhere, German Chancellor Merkel’s approval ratings have collapsed amid Europe’s Syrian refugee crisis, and Euroskeptic parties have gained ground in many EU countries ahead of key leadership elections in both Germany and France in 2017. And while most economists would describe the current settings of global monetary policy as accommodative, both the ECB and BoJ failed to live up to somewhat lofty expectations of additional easing measures at their respective meetings on September 8 and September 21.
Meanwhile, the cloud over U.S. economic health in the wake of a weak ISM Manufacturing read on September 1 has been substantiated by a -0.55 value for the August Chicago Fed National Activity Indicator (CFNAI). We have discussed our fondness for this single variable in the past because it is a composite of 85 different indicators of broad economic activity. While the month-to-month data can be volatile, historically a 3-month moving average value of -0.7 for the CFNAI has marked a recession. As a point of reference, this indicator crossed the -0.7 threshold in February 2008, well before the market turmoil caused by the global financial crisis hit in the summer and fall of that fateful year. Suffice it to say, we are keeping a close eye on the economic data coming out of developed markets over the coming weeks for signs of a break in one direction or the other.
But it also seems just as likely to us that we will be having the same conversations a year from now as we have been having for the past couple of years. Namely, how much longer can the “muddle through” environment of below-trend global growth last, and are risk assets overvalued in this context? To answer these questions, we believe the Reinhart & Rogoff findings published in their 2009 book, This Time is Different, are instructive. They show that historical instances of debt and banking sector crises have remarkably similar consequences across time and geography. In some instances, the effects upon certain segments of the economy can last for five or six years after the crisis. But it is also important to remember that there is a distribution around that average. So while the United States is now seven years past the great recession, Europe is only four years removed from its sovereign credit crisis that persisted through 2010 and 2011, and thus well within a period in which you would still expect lingering effects on real GDP, employment, and inflation.
Barring some substantial shock, muddle-through is a reasonable null hypothesis, and the current state of affairs in global capital markets can persist. This all paints a rather subdued picture for risky assets with valuations on the high side and expectations for a strong earnings rebound in 2017 already priced in. We would describe ourselves as very slightly bullish with heightened vigilance heading into the finish line for 2016.
The debate over “safe stocks” hinges on definitions
On a final note, we have observed a growing chorus of opinion that “safe” stocks are extremely overvalued in the equity market. However, “safe stocks” is a vaguely defined term: It could mean stocks with lower-than-average volatility, lower-than-average earnings variability, or something else entirely. Empirically, we find no evidence to support the claim that “higher quality” stocks (which is how we define less-volatile stocks with below-average earnings variability) are expensive. To measure this carefully, we adjust for sector composition and then measure the valuation differential between the top and bottom quintiles of our quality metrics. We find, in general, the evidence of a valuation gap between safe and unsafe is weak to nonexistent. Relative to their own history, these stocks look more expensive than usual, but then so does the entire equity market. And finally, we would posit that these valuation conditions might be simply an efficient and rational response to historically low real and nominal interest rates.