Will QT hurt?

Will QT hurt?

09-11-2017 | 年次アウトルック
Equity rallies that have moved into ‘extra time’ could result in penalties with the dawn of quantitative tightening.
  • Peter van der Welle
    Peter
    van der Welle
    Strategist

The S&P, Nasdaq, Dow and many other major stock market indices have hit all-time highs. Stock market volatility had dropped to record lows. To date, the year’s maximum drawdown on the S&P has been 2.8%, one of the lowest levels in history. The old bull market that used to be referred to as “climbing the wall of worry” seems to have morphed into a more exuberant version of itself, which is typical for a mature phase of a bull market.

Judging by market action year-to-date, we are now in extra time. The wall (consisting of high stock market valuations, leverage and geopolitical uncertainty, to name but a few) still very much exists, but people just worry about it less. For instance, the record low VIX has recently shown an unusual divergence from measured levels of geopolitical risk.

The prospect of missing out on price action has captured the imagination more than the fear of shaky fundamentals, a phenomenon also seen in current cryptocurrency markets. At first glance, this appears to be a momentum-driven market, where every dip is steamrolled by new demand for risky assets.

Investment outlook 2018
Investment outlook 2018

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Source: Bloomberg, Robeco

As in physics, momentum for any system is only conserved in the absence of an external shock. Upon closer examination of the very high SKEW (which measures the price of tail risk on the S&P 500) compared to the VIX, market participants do not appear to be naïve about external shocks, and are willing to pay up to hedge tail risks while joining in the positive momentum. Though equity investors in this phase of the bull market may exhibit signs of exuberance, it does not yet seem to be the type of irrational exuberance that could spell the imminent demise of a bull market.

Indeed, this stock market is still about much more than ‘close your eyes and buy’. Stock market indices may have surged (with emerging markets in the lead with a 30% gain year-to-date), but so have numerous consumer – and producer – confidence indices, indicating a resilient global expansion that is accelerating and broadening.

Very solid reported corporate earnings growth in major equity markets over the year also provide evidence of sustained macro-momentum. According to analysts’ forward earnings projections, forward 12-month earnings growth will be around double digits in the US and Europe. This is not unrealistic in our view, as we expect the Eurozone and US economic expansions to power ahead at a solid pace in 2018, with the Eurozone even boasting above-trend growth.

In the earlier stages of this bull market, profit margins rebounding to record highs have led to a recovery in earnings. With labor markets strengthening and the peak in monetary easing behind us, this earnings driver will be gradually losing strength. In the third half, we see earnings growth becoming more reliant on rebounding sales growth on the back of an optimistic consumer. Rebounding global sales activity year-to-date reflects global consumers (especially those in the US, which are leading the global cycle) who are confident of improvements in future disposable income driven by wage growth, housing wealth and lower tax rates.

Of course, confidence in the rise of future incomes would quickly erode if the global economy hits an obstacle that triggers a recession. Since 1854, recessions in the US have occurred on average once every five years. With this expansion now in its eighth year, we are overdue for a recession, which begs the question; how long can this period of extra time last for the equities bull market? Equity markets typically start to decline four months prior to a recession.

Judging by the ISM manufacturing survey, the risk of recession still seems fairly low. Based on the past ten US recessions, it takes an average of 35 (median 31) months after a cyclical peak in the ISM manufacturing survey for a recession to develop in the US. This suggests that even if the recent ISM (at 60.8 at its the highest level since 2009) has marked the peak of the US economic expansion since the financial crisis, a recession remains a pretty remote risk, and the current growth in trade can continue for the time being.

With earnings growth now largely underpinning stock market returns instead of easy money, it comes as no surprise the S&P 500 has recently decoupled from the Fed’s balance sheet evolution, as shown in the graph. This chart should reassure Fed board members that their balance sheet reduction, of which they have given extensive warning, will probably not bring the stock market to its knees.

Still, the rising interest rates that will result from balance sheet reduction and further conventional tightening could limit multiple expansion further down the road, especially as US stocks have already moved up considerably in the expensive phase. It seems more likely, however, that the current positive momentum will push stocks even higher.

This article forms part of the Robeco 2018 outlook entitled Playing in Extra Time.

Investment outlook 2018
Investment outlook 2018

Playing in extra time

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