Equities not in denial of new bear market, yet
LAST YEAR, global equity markets had the worst run for any calendar year since 2008, with developed-market equities, as measured by the MSCI World Index, ending the year down by more than 10 percent in dollar terms.
Investors in the local market also experienced their worst calendar year since 2008 as the market, as measured by the FTSE/JSE All Share Index, slumped by more than 11 percent.
This year has started off on a very positive note – the US market (S&P 500 Index) is up nearly 9 percent, developed markets outside the US (MSCI World Ex US Index) advanced by about 8 percent in dollar terms, while emerging markets (MSCI Emerging Market Index) have also gained nearly 9 percent.
The JSE gained only 2.8 percent, but more than 10 percent in dollar terms as the rand surged against the greenback.
The question most investors and market commentators wrestle with is whether the current rally is sustainable or a bull trap – a false signal that the market has reversed a downtrend in prices.
The popular narrative today is that the inversion of the yield curve in the US is a precursor to an imminent recession and that the massive rally in the equity market since the end of last year is nothing more than a trap.
Inversion of the yield curve is when yields of long-dated government bonds fall below the federal funds rate – the central interest rate in the US financial market as it influences other interest rates such as bank overdraft rates, mortgage rates and rates on savings.
The inversion of the yield curve normally occurs when the economy reaches full employment and the Fed needs to rein in the economy and quell demand to guard against upward inflation pressures. Yes, it is true that in previous cycles, yield-curve inversions eventually led to recessions.
I use the US yield curve as defined by the spread between 10-year and two-year government bond yields, as the latter is a very good indicator of what the market expects about shorter-term interest rates.
Before the recent downturns started in 2000 and 2007, the yield curve remained flat – the spread between the 10-year and two-year government bond yields close to zero – for 22 and 20 months respectively, while the unemployment rate remained below 5 percent.
In the current cycle, the yield curve has been virtually flat for nine consecutive months since June last year. If the durations of flat yield curves during the previous cycles are repeated, the outlook for the US economy and company profits could thus remain solid over the next three to four quarters.
What we also know is that the up-trend of the S&P 500 Composite Index, as a proxy for the US equity market since 2009, remains intact.
Elsewhere in the world, growth in developed economies such as Germany, Japan and the UK are slowing down, while the French economy is showing signs of contraction.
It is reflected in the behaviour of the stock market, as measured by the MSCI World ex USA index, which is down by about 9 percent in dollars over the past 12 months, and despite the recent rally, still down by 6 percent since the end of the third quarter of last year.
The MSCI World ex USA index has underperformed US stocks by about 55 percent since July 2008, rendering those markets, as measured by the MSCI World ex USA index-tracking ETFs, to trade at discounts to the US market (S&P 500 Index) of 35 percent and 50 percent based on price-to-earnings and price-to-book value multiples respectively.
It is therefore evident that a lot of bad news is already reflected in those stock markets and that the current stages of the economic cycle of the developed economies are already priced in.
Economic growth in China, the world’s second largest economy, continues to slow despite government efforts to stabilise employment and support domestic demand amid the trade war with the US.
In contrast, the other major developing economies – Russia, Brazil and India – are experiencing stronger growth. This is reflected in the recent outperformance of emerging market equities. Although still down more than 16 percent since January last year, the MSCI Emerging Markets Index made up all its losses since the end of the third quarter last year and outperformed stock markets in developed countries.
Emerging-market equities, as measured by emerging market index-tracking ETFs, are currently trading at discounts to the US market of 39 percent and 49 percent respectively, based on price-to-earnings and price-to-book value multiples.
To me it appears that what we have seen is a healthy correction in a bull market and that the strong rally since the end of last year is not a denial of a new bear market… yet.
Ryk de Klerk is an independent analyst. Contact rdek@iafrica.com. His views expressed above are his own. You should consult your broker and/or investment adviser for advice.