From the Sunday Start column by Morgan Stanley’s Graham Secker, head of European Equity Strategy
Is the Tide Rising?
It is often said that a rising tide lifts all boats, but perhaps the more pertinent question just now is whether this logic works in reverse. July saw over 80% of European companies post a rise in their share price, and performance has remained strong so far this month. This breadth of positive returns has been a rare occurrence in Europe in recent years, but does this augur an upturn in economic activity ahead or is it a sign that investor optimism has overreached?
With most global and regional economic surprise indices close to multi-year highs, it does indeed appear that the recent move higher in share prices is backed by better economic data. It is noteworthy that global share prices have been tracking the global economic surprise index more and more closely in recent months to the extent that the 3-month correlation between the two series is up to a blistering 88%.
In the current environment good news is good news, we believe, but given this extreme correlation, investors should be cognisant that such surprise indices are mean-reverting by their very nature and that, more fundamentally, traditional economic lead indicators such as PMIs are now stable rather than accelerating.
Given our economists’ relatively cautious and below-consensus GDP forecasts, we do not believe it is right to bet on a further rise in economic optimism from here.
With the benefit of hindsight we can see that better-than-expected near-term economic newsflow and the implementation of further monetary stimulus can be cited as factors driving equities higher over the last couple of months. However, rumbling below the surface is a debate on whether reflation is really afoot, perhaps boosted by upcoming fiscal initiatives.
Despite outperformance from traditional reflation plays such as EM and commodity-related assets, and even a modest pick-up in financials’ performance, we do not believe that investors should position for reflation per se.
In fact, signals from other markets provide little evidence of growing reflation hopes, with US 5Y5Y inflation expectations rolling back over in the last two weeks, yield curves stubbornly refusing to steepen, and the slow but persistent ongoing depreciation of CNY.
A weaker China exchange rate is a particular issue for Europe and Japan as they battle against the combination of low growth, low inflation and a rising currency. On a trade-weighted basis both EUR and JPY have risen to their highest levels post the initiation of their respective QE programmes, hampering the scope for an upturn in corporate profits and weighing on their relative performance.
Our FX strategists remain bullish on both currencies, while we continue to prefer US and EM over Europe and Japan within equity markets. Note that our Dec-17 EPS forecasts for the latter two regions are 11% and 20% below consensus, respectively and, consequently, we have a general bias towards quality and defensive stocks.
Our subdued view of the global macro and corporate earnings backdrop appears to be increasingly at odds with stock market performance and sentiment. While few investors we meet express outright optimism on the growth outlook, it appears that the persistent grind higher in equities, coupled with very attractive relative valuations, is drawing investors in.
A sharp drop in short interest in the US supports the idea that we’re seeing something of a capitulation from the bears, while many other quantitative sentiment metrics we track are very elevated versus history.
Although equity valuations continue to look extremely attractive relative to bonds, there is always a plausible argument that the equity rally will continue; however, this is potentially the most dangerous time for investors as hope and greed overtake fear and loathing.
