Equity rally to be sustained only with central bank help
There is a disconnect between what equity and bond market performance is telling us about the outlook for the global economy, and the performance of different asset classes that matter for investors. It bears the fingerprints of the US Federal Reserve and the European Central Bank’s dovish policy stance.
The first quarter of 2019 delivered good returns for equity markets as measured using MSCI indices, with almost every major region in positive territory. Global equities were up by 12.3%, driven by advanced and emerging-market equities,
which rose 13% and 10% respectively after broad-based declines of similar magnitude in the last quarter of 2018.
In advanced economies, the US, Europe and UK equity markets gained 13.3%, 9.7% and 9.4% in the first quarter of 2019. In emerging markets, all the Brics countries’ equities delivered gains, China leading with 18% and SA lagging with 4% and the other three somewhere in between.
Looking at these performances alone would indicate a healthy global economic growth environment, but other pieces of data point in the exact opposite direction. The Citi global surprise index, which measures the difference between expected and actual real economic activity, has been in negative territory since April 2018 and has been getting more negative since September 2018. This implies the market has been overestimating how strong the economy is, which is confirmed by Bloomberg consensus estimates of growth in major economies such as the US, eurozone, UK and China being revised downwards, especially for 2020.
The JPMorgan global manufacturing PMI, which measures the health of the global manufacturing sector, peaked at 54 points in December 2017 before moderating consistently through 2018 and in the first quarter of 2019, reaching 50.6 in March. With a level of 50 separating expansion from contraction, this implies that the global manufacturing sector is stagnant.
Let’s set aside the debate on whether markets are efficient and assume they largely are. In that case, we may believe equity markets are right to be optimistic about the outlook. The bond market, however, is pessimistic. The US yield curve
the difference between shortand long-dated bond yields has inverted, which has preceded seven of the past seven US recessions. Some analysts are dismissing the current US yield curve inversion, saying this time it is different. Let me reluctantly concede for a moment and say perhaps not a recession but a growth slump or a soft landing is coming about four to five quarters from now if history is anything to go by.
The IMF’s April world economic outlook revised the global economic growth forecast for 2019 down to the slowest pace since 2009 at 3.3%, from its January forecast of 3.5%. Of greater concern is that the slowdown is broad-based, with 70% of the value of the world economy moderating.
To reconcile these pieces of information, it is clear that equity markets are in a shortterm bull market fuelled by global central banks’ monetary support and easing trade tensions. But there are risks in this view. Central banks turn dovish for a reason, and historically do so when they are staring a significant economic slowdown in the face.
This equity rally will be sustained only if central banks reinstitute quantitative easing or cut interest rates in response to weakening real economic activity, as shown by the Citi global surprise index and the moderating JPMorgan manufacturing PMI, which is corroborated by downward revisions in economic growth forecasts by market participants and the IMF. The Fed funds rate is pricing in a probability of rate cuts in the US, which is consistent with equity market performance.
The second-quarter US earnings season will offer some clues to where global equity markets will go next. My sense is that we will see a moderation given that bond markets, economic growth estimates and incoming real economic activity are all pointed in that direction. This matters for SA investors because global market dynamics dominate local factors, and if global markets sell off we will go down with them.
● Mhlanga is executive chief economist at Alexander Forbes.