Equity bull markets do not tend to die of old age, or even as a result of high valuations; they tend to end when fears of recession rise.
That’s from Goldman and it’s fucking silly.
Read that again. Now imagine someone telling you the following:
People do not tend to die of old age, they to die of other things.
I mean “yes,” people do “tend” to die of things other than old age, but if those things don’t happen, then old age will get you every time.
What would be the alternative? I guess something like this:
Equity bull markets do not tend to die of old age, or even as a result of high valuations, so in the absence of recession fears, stocks will go to infinity.
People do not tend to die of old age, so in the absence of disease, people will live forever.
Ok, so having established that the premise is patently ridiculous, we can move to consider if what follows from it has any merit because contrary to popular belief, a flawed premise doesn’t render everything that comes after it useless.
Here’s what Goldman set out to explore:
- The ‘reflation’ excitement that drove up inflation expectations, bond yields and equity prices between July 2016 and February 2017 has started to fade. Some of this reflects the moderation of recent macro data surveys.
- While the global economic cycle may be past its peak rate of acceleration, global growth remains decent and well balanced. The global equity bull market is likely to continue. Equity bull markets do not tend to die of old age, or even as a result of high valuations; they tend to end when fears of recession rise. We believe that we remain some way off these risks becoming prominent in investors’ minds.
- That said, high valuations coupled with a slowdown in the rate of growth is consistent with weaker returns in equity markets. The slowdown phase should also be consistent with non US equities outperforming (as we continue to forecast).
Excerpted below is the accompanying color along with some visuals.
A simple search count on Google demonstrates how the focus has changed. In Exhibit 1 numbers represent search interest relative to the highest point on the chart for the given region and time (a value of 100 is the peak popularity for the term. A value of 50 means that the term is half as popular. Likewise a score of 0 means the term was less than 1% as popular as the peak). Searches on deflation peaked at the start of 2015 whereas searches on reflation exploded in 2H 2016 and have since tailed off dramatically.
This aligns with some of the most recent survey data, which has started to slow, particularly in the US and China. We believe this does not imply that the bull market in equities is nearing an end. Indeed, despite weaker data in some areas, our own global current activity indicator (CAI) is running at +4.6% in April comprising DM at +3.1% and EM +5.8% (although down from +6.2% in March). Also equity bull markets do not die of old age but rather from worries about recession. At this stage, despite a period of slower growth momentum, recession risks appear low.
Low recession probability helps to explain the low level of volatility in markets. Indeed, S&P 500 1-month implied volatility hit the lowest level on record this week (since 1988) while S&P 500 1-month realised vol remains stubbornly low at 7% (8th percentile since 1928). The S&P 500 has increased for 313 days without a 10% drawdown and 221 days without a 5% drawdown. But while recession risks are low, a slowdown in the rate of growth is consistent with higher volatility and lower returns in markets. This raises the question: how much of a slowdown are markets pricing and does this vary much from region to region?
Measures of inflation expectations have moderated from their highs at the end of last year (Exhibit 4) and bond yields have fallen back to some extent (Exhibit 5), although not to the lows experienced in the middle of last year.
Taking the relative performance of cyclical versus defensive sectors of the equity market gives us one barometer of how much reflation or moderation is priced in to markets.
Cyclical versus defensive
On a global basis the relative performance of cyclical against defensive sectors has typically mapped the global PMI quite closely (Exhibit 6).
Exhibit 7 shows the performance of cyclicals versus defensives in each major region since the start of 2016. All regions enjoyed a strong bounce in this pair from the lows last July. This coincided with the recovery in bond yields from record low levels. In most regions the relative performance of cyclicals against defensives between January and March has been fairly flat; since then cyclicals have generally underperformed defensives.
Our view is that this pullback has been generally justified by the slowdown in the momentum of growth. We would expect further underperformance of selected cyclicals over the coming months unless global bond yields rise further
Value vs. growth
Exhibits 9 and 10 show similar patterns for the ‘value’ versus ‘growth’ factors.
In our view ‘value’ offers a better risk reward than cyclicals overall at the current stage, although in some cases there are cyclicals that still represent value. For example, in many markets value is heavily geared towards financials.
Financials vs. defensives
The point about financials forming an important part of the ‘value’ factor can be seen in Exhibits 11 and 12. These show the relative performance in each market between financials and defensives – this factor has been both closely related to growth expectations and also to global bond yields and inflation expectations.
We believe that financials remain broadly attractive in all regions (although our Japan team has downgraded banks to Neutral given strong outperformance and a lack of a short-term catalyst).
Low vol vs. the market
Another important factor that has acted as a barometer of the deflation/reflation dynamic has been volatility. In general high uncertainty and falling growth expectations over recent years have resulted in stronger performance in low volatility companies relative to the broader equity market. As global bond yields reached a trough and growth expectations picked up last July, lower volatility stocks trailed in relative performance as investors moved into more cyclical and higher beta stocks. Once again this has partly reversed post the peak in bond yields last December.
With a slower pace of growth we think investors are likely to reward companies that enjoy a combination of reasonable valuations but that can also exhibit lower volatility growth