As the market has swung from despair in the first half of Q1 to sheer, central-bank driven euphoria, here are some words of cautin from SocGen's Andrew Lapthorne.
From sanguine-to-bearish-to-complacent – What next?
So far 2016 has been quite an emotional roller coaster, with equity markets having gone from sanguine-to-bearish-to-complacent in the space of just 64 trading days. At one point having been down almost 12% YTD, MSCI World has finished the quarter almost flat. Emerging Markets are now up 5.4% YTD, believe it or not. Equity volatility, as measured by VIX, having jumped from 18 to 28 by mid-quarter now finds itself sub 14 – its lowest level since August last year, prior to the devaluation of the Yuan, and a level normally associated with the good times.
However the outlook remains shaky, with the first quarter seeing substantial downward revisions to global GDP and global profit expectations. The consensus is now pencilling in very low single digit EPS growth in most regions in 2016, which given the current pace of downgrades is likely to run negative within the next few months. Even trailing US S&P 500 pro-forma EPS growth (i.e., excluding all the bad stuff) has turned negative during the last few weeks – a feat never seen outside of a US recession.
These cyclical concerns are reflected in the strong outperformance of bonds during the quarter, with most 10 year sovereign bonds delivering around 4-5% and the more defensive equity styles clearly positive in Q1, with the likes of our SGQI index up 5.5% YTD, whilst our more cyclical and Japan exposed SGVB index is off 3.8%. Japan had a dire quarter, with a disastrous foray into negative rates (depriving the market of a much desired increase in QE), along with a sharp rally in the Yen leading to a slump in the Nikkei 225, which remains down 12.8% year-to-date. Yet surprisingly the Japan smallcaps Mothers index is up 12.9%.
The Fed is increasingly worried about these ever-weaker fundamentals, yet asset markets seem more preoccupied with the omnipresence of the Fed put than downside cyclical risk. This then perhaps points to the bigger underlying concern for investors, the overwhelming build-up of leverage in the system. For in the absence of sensible drivers of returns (i.e. sensible interest rates, EPS growth etc.), investors and corporates resort to leverage. Without earnings growth, corporates have been bringing on debt to buy back shares. With miserly rates of return on offer in fixed income markets, investors are leveraging up. The longer the Fed feeds this game, the bigger the mess when the inevitable downswing comes along.