When a market narrative shifts, investors should be sure to weigh the merits of the new message.
No matter that much of the current economic data is murky, or that the road toward a trade resolution between Washington and Beijing is a long and winding one. There is no mistaking the changed mood of financial markets: the threat of a hard landing for the global economy is behind us, and a rebound beckons.
But the extent and scope of an economic recovery in 2020 remains very much a point of conjecture. Bullish equity-market sentiment ultimately requires a substantial rebound in business investment that reflates the global economy. Evidence of such a surge may not arrive until the spring of next year at the earliest.
November has provided some signs that the worst of the soft patch is behind the global economy, while reports emerging from the ongoing US-China trade talks suggest that both sides can see plenty to gain from a deal. As a result, global bond yields have climbed to their highest levels in more than three months, with ten-year yields in France back above zero for the first time since July.
Record highs for various equity markets are being characterised by big rotations between sectors and regions. Leadership has tilted in favour of cyclical sectors that tend to do better when economic activity is stronger. So-called “value” shares — typified by global financials, which have been hit hard by negative interest rates in Japan and Europe, and then the summer fears of recession — are powering up.
This trend is amplified by rising long-dated government bond yields, which normally benefit banks as they can lend at higher rates while their cost of funding is negligible. The recovery in global financial stocks has mirrored the rise in global bond yields since mid-August, prompting talk that the rotation towards value, the bargain bin of equities, has more room to run.
Equity markets in Europe and the Asia-Pacific region — with their big weightings of financials and value candidates — have outperformed even a record-setting Wall Street. Investors are overlooking quarterly results which show profits falling for both S&P 500 and Stoxx 600 companies, preferring to focus on sunnier forecasts for next year.
True, equities have endured periods of falling earnings in the past. At the moment, the S&P 500 is on course to match the fallow run recorded over four consecutive quarters spanning 2015 and 2016. The current bullish sentiment reflects plenty of faith that the squeezing of profit margins will abate for both European and US companies next year, as growth picks up.
The shift in mood is illustrated by the 25 per cent jump in the share price of Caterpillar over the past month. The stock of the heavy machinery maker, which is often seen as a barometer of the global industrial economy, was lower for the year by some 7 per cent in early October. That was before the company reported disappointing earnings and lowered guidance for the full year. No matter: this week the stock registered a fresh 52 week high. As an investment manager explained to me, the resurgence in the company’s stock tells us that earnings and recession fears were overdone. The pendulum is swinging back.
Another consideration is that the brighter signs over trade mask a much more powerful driver of longer-term bullish sentiment: expectations of fiscal stimulus. Greater government spending is certainly on the agenda for the UK economy and an equity market that has been largely ignored by foreign investors, who have favoured gilts since the 2016 Brexit referendum. It is not difficult to build a case for a rotation into stocks and out of government debt as the Treasury ramps up spending in 2020.
Across the channel, the recent performance of European shares and cyclicals also reflects in part expectations of greater state spending — even from a reluctant Germany — and a growing recognition of the damage inflicted by negative interest rates in some policymaking circles.
The prospect of fiscal ammunition being deployed, along with fading prospects of an escalation in the trade war, explains much of the current enthusiasm within equity markets.
Not everyone is convinced that this marks the start of a radical change for investment strategies that have grown dependent on high-quality bonds and stocks. The trends of modest economic growth in mature economies, and slowing momentum across the emerging world, appear well entrenched.
David Bianco, chief investment officer for the Americas at DWS, the asset manager, says that he and his colleagues still find it hard to “abandon our longstanding preference for profitable growth stocks over cyclical value stocks.’’
As a clearing house of countless information and investment decisions, markets generate plenty of noise and at times, misleading signals. Responding to the right ones is the challenge facing investors as they tweak portfolios for the year ahead.