According to Morgan Stanley's European equity strategist, Graham Secker, we may have just hit peak bearishness. However, does that mean that a rebound in risk sentiment is imminent, or is this just the beginning of a multi-decade mean reversion, one that will seek to unwind years of central bank intervention, and push risk assets to their ex-central bank prop fair values?
We don't the answer just yet, although it seems unlikely that after one humiliating episode in recent months for the ECB, Fed and BOJ, each, they will simply pack up and go.
For now, however, here is Morgan Stanley, with a summary of not only why everyone is "peak bearish", but why the one potential downside catalyst most are ignoring, namely Europe, is about to take its rightful place in the pantheon of risk factors for 2016.
A Sleuth of Bears
We struggle to remember many occasions when investor sentiment was quite as bearish and widespread as it feels today. Sure, 2008 was worse as the global financial crisis and fears of global depression created panic in markets, but today’s cool disdain for risk assets still takes some beating. When we were asked by a client this week what reason bullish investors were citing for their optimism, we had to confess that we couldn’t answer as we hadn’t met any in recent times. The collective noun for a group of bears is a ‘sleuth’, but it doesn’t take much detective work just now to identify what investors are concerned about.
Moderating growth expectations are likely one reason for this more cautious approach, although it’s hard to argue that we’ve seen a step-change down in the macro data. From our seat we believe that current concerns reflect a rising probability of a ‘bear case’ outcome as much, if not more, than a more muted ‘base case’. For us the most plausible bear case outcome, aside from general economic recession, contains a mix of China policy concerns (especially FX), USD strength, falling commodity prices, poor EM newsflow and asset performance, and geopolitical uncertainty including the US presidential election and Brexit. A number of these attributes have featured highly in market newsflow in recent weeks.
The sharp falls seen in risk assets are now starting to prompt a central bank response that, when combined with low investor sentiment, does increase the potential for two-way (as opposed to one-way) volatility in markets. However, absent an improvement in fundamental newsflow, we fear that any relief rallies will prove short-lived as investors increasingly question the value and effectiveness of further central bank action.
In this respect, the growing perception that central banks are moving away from QE-style programmes to negative interest rates is less supportive for equities, in our opinion. With little evidence so far that negative rates boost aggregate economic activity, the risk is that this policy tool increasingly resembles a more blatant form of 'beggar thy neighbour' currency devaluation. A shift towards a more nationalistic and perhaps less coordinated global policy response could signal a quickening in the pace of fiat currency debasement and augurs badly for risk appetite, in our view.
Part of our positive thesis on DM equities in recent years, up until our downgrade in December, had been predicated on their attractive valuation relative to other asset classes. However, in periods of heightened uncertainty, relative valuations provide much less solace to investors and absolute valuations tend to take over. On this basis it’s hard to argue that equities are cheap enough to trough on valuation grounds alone, given that MSCI World’s trailing P/E, P/BV and DY are only around 0.5SD below their 30-year averages and the trailing P/E for the global median stock is exactly in line with its long-run average of 20.5.
One noteworthy aspect in the current risk-off environment is the lack of peripheral spread widening in Europe; this is unusual based on performance patterns during this cycle and most likely reflects the ECB’s substantial QE programme. While the region is often perceived as a relative consensus overweight among equity investors, we are more downbeat and prefer the US and Japan instead. Our European caution primarily reflects the prospect of further earnings disappointment across the region, but we are also wary of any resumption of geopolitical concerns.
Recent investor caution tends to focus on fears of excess USD strength, low oil prices and/or China, but we think it is quite plausible that Europe moves back up the pecking order (to its more usual place some would say!) as we move through 2016. The UK’s forthcoming referendum on EU membership, likely to take place in June, may appear the most plausible catalyst in the short term to raise regional risk premia, but the ongoing migrant issue risks eroding political cohesion over the medium term and political uncertainty is rising in the periphery. Greece has a daunting debt repayment due this summer, Spain is currently without a government, new European regulations are preventing Italy from adopting an effective ‘bad bank’ solution and the recently elected socialist government in Portugal is reversing course on prior austerity and competitiveness improvements. During a cyclical upswing, markets are prone to overlook such concerns, but the opposite would be true if growth starts to relapse.