Bullish sentiment begins to ring alarm bells

12 January 2018

The new year is starting up with a dynamic in global capital markets that even the bulk of the optimistic forecasts had not anticipated. This is somewhat at odds with the UK’s domestic situation where another miscalculation by the government’s leadership, resulted once again in the exact opposite effect to the one it aimed to achieve. Gloomy news of contracting Christmas sales volumes on the UK’s high streets, the strained NHS buckling under a particularly severe winter cold and flu season and even worse than normal train commuter misery in the South East rounded the picture of a fairly miserable start the year. Had it not been for the reports of record manufacturing and export figures one might have thought the UK had de-coupled from the rest of the world.

The rest of the world is seemingly running into the opposite problem - things are beginning to run too well for comfort. The continued rally in equity markets and new highs in investor sentiment tells us and others that the last ‘bears’ must have capitulated, while the macro economic news-flow and a strong corporate earnings outlook provide further support to all who have started 2018 with new found optimism. The short but fierce bond market sell-off mid-week came therefore as a very timely warning signal to all that argue that the 2017 low volatility ‘goldilocks’ market environment will carry forward indefinitely. The oil price surpassing the $70/bbl threshold for the first time since 2014 despite little fundamental changes in the demand-supply balance may be seen as another sign that things may be getting out of hand.

We are therefore this week dedicating considerable space inside the Tatton Weekly to a fundamental assessment of corporate growth dynamics around the world and the theory and practice of translating those into valuation levels for stock markets. We find that US corporate profits are surprisingly still outgrowing the Eurozone’s. However, the US stock market is also at potentially historical highs in terms of relative valuations. That is at least, if the recent growth dynamic was to show any signs of slowing. The economic data for the last quarter of 2017 tells us that all was going very well, with few signs of slowing - if it was not for concerns that it may not last because the dynamic might force central banks to remove the monetary life support of QE and ultra-low rates sooner than anticipated. This would explain the episode of the rapid rise in US treasury yields as the underlying bonds sold off, after rumours made the round that there may be waning demand for them by China and Japan.

It is therefore bond market development we have to monitor more closely right now than stock markets. Stock markets may be trading high, but at least they are supported by growing corporate results. Bonds on the other hand with their now extremely low future income streams from historically low yields are far more vulnerable to investor stampedes as they lack the coupon cushion of old while stock shine once again with growth and dividend prospects. Unfortunately, the two sides of the capital markets remain interlinked and a sudden and lasting rise in bond yields from a bond bear market has historically been bad news for stocks. Many reasons are given for this relationship, but the most important in our view tends to be that yields rise out of inflation fears, which arise from rising wages which undermine corporate profits. Put together with the experience that this usually happens when the economy overheats towards the end of an economic cycle and one can see the ingredients for a perfect storm for equity markets.

Before anybody feels tempted to panic, none of the above has happened or is happening and the reason why the economy and markets are currently so buoyant is the absence of any significant inflation pressure and only minimal yield increases thus far.

At the same time, we should not kid ourselves that, at current bond yield levels, only very gradual changes in real and expected inflation levels and similarly glacial monetary tightening by central banks as a consequence, will allow a normalisation of bond market conditions without undesired side effects. The dominating watch point for 2018 will therefore be wage dynamics and how central banks adjust their policy measures to a changing environment.

As we have said here before, in such a fragile equilibrium between economic optimism and bond market fear, we would not be surprised to see a return of the occasional bout of stock market upsets, with short but fierce correction cycles. While the global economy continues to expand and corporates reap the rewards we can reasonably expect stock markets to grind higher regardless. The higher they go, however, the more we need to be prepared to experience occasional stock market setback. Persistent equity downturns on the other hand only happen when the economic outlook decisively turns negative - for the moment we are witnessing the precise opposite - but we will have to watch further developments very closely - stay tuned.

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