Do stockmarkets lead the leading indicators? It sounds like a silly question but at the beginning of the year that was exactly what many investors seemed to think.
Equities were sold off heavily in the first few months and the lower they went the louder the talk of a global downturn became. The chances of a recession, implied by global share markets, were a coin-toss in mid-February. But when we look at eight tried leading macroeconomic indicators the risk peaked at just 5 per cent.
Other market measures that tend to provide reliable forecasts of recession, such as credit spreads or the two- to 10-year government bond yield curve, also contrasted starkly with the Armageddon scenario suggested by equities.
We drove even further into this by running a complicated statistical calculation – factor analysis – on a collection of markets that should be heavily reliant on US economic growth for their performance.
This analysis showed markets were implying an economic outlook far gloomier than that provided by the leading macro data, which the market-implied “growth factor” is usually closely correlated to.
The likelihood of recession is important for asset allocation, as there has only once been a bear market (of the S&P 500) without one. That exception was 1987’s Black Monday crash. There have been sizeable market falls without recessions but these episodes are rare, and markets almost always recouped their losses within 12 months.
Shifting fundamentals or sentiment?
It is important that long-term investors question whether market corrections are due to economic shifts or simply to a wave of negative sentiment. Markets can usually shrug off negative emotion in a couple of months. Economic changes can be tectonic shifts that alter the investment landscape for years to come.
We believe the latest bout of turbulence is an example of fear rather than fundamentals. Measures of the market’s mood, such as the put-to-call ratio or the American Association of Individual Investors Sentiment Survey, have already moved away from the extreme readings of early February. There has also been anecdotal evidence of some sovereign wealth funds selling assets to help plug cavernous budget deficits in economies that depend on exporting commodities. This has probably amplified the market’s turbulence and caused prices to drift even further from those justified by macro fundamentals.
“Markets must question whether corrections are due to economic shits or negative sentiment”
Although we have only estimates at this stage, it looks likely that last year was the first in more than a decade when sovereign wealth fund assets did not grow. Most of their inflows were from nations rich in natural resources that benefited from the commodities supercycle and its profits boom.
Following the slump in oil and ore prices, this flow of money has slowed to a trickle.
We acknowledge the macro outlook has softened and there are an uncomfortable number of concerns that temper our enthusiasm — most notably Chinese industry and shaky European banks. Yet the reaction to the dawning realisation of these risks over the past nine months appears extreme.
So, do you follow the leading indictors of economic activity or put your trust in the clamour of equity markets?
We prefer to base our reasoning on rock-hard facts, not clouds of emotion.
Edward Smith is asset allocation strategist at Rathbones