Who will be the marginal buyer of equities going forward?
That’s a question that’s troubled the market since February, when the VIX shock reminded retail investors that stocks sometimes fall (who knew?!) and threw cold water on the idea that you too can quit your day job coordinating the cigarette break schedule at Target in order to pursue an exciting career shorting vol. from your living room.
Although tech and small caps managed to make new highs, what was smooth sailing in January has since turned into a halting, arduous affair characterized by a creeping suspicion that eventually, U.S. stocks will catch down to the rest of the world’s reality.
That’s not to say there aren’t tailwinds in the U.S. In fact, there are several including (obviously) brisk earnings growth and the corporate bid (i.e., buybacks). Indeed, there’s a a strong argument to be made that the latter (buybacks) accounted for U.S. stocks’ relative resilience in Q2.
But what if earnings growth fails to live up to expectations or otherwise fades quickly as the sugar high from late-cycle fiscal stimulus in the U.S. wears off?
As Morgan Stanley put it on Sunday in the course of cutting tech to underweight, “while we are not worried about an economic recession as the catalyst for underperformance in these market leaders like it was back in early 2016, we do think that 2Q earnings season will bring an inevitable acknowledgement from companies that trade tensions increase the risk to forward earnings estimates, even if managements don’t formally lower the bar.”
If the adrenaline rush from fiscal stimulus were to wear off and momentum were to stay mired in the mud of trade tensions and economic policy uncertainty, it’s possible that institutional investors and trend followers might be reluctant to re-risk. Consider this from a SocGen note dated June 27:
With the volatility bout in February, global markets appear to have ushered in a new regime of high volatility coupled with a lack of enduring directional trends. Markets are pulled by the promises of late stage economic growth boosted by monetary and fiscal stimulus. They are also contending against the risks of rising geopolitical tensions and the likelihood of potential recession. So they end up moving up and down with no clear direction.
Such sideways markets are challenging for convex strategies such as trend following systems. With their convex profile, trend-following systems offer strong positive returns in long lasting bear markets while participating positively to the upside in extremely bullish regimes (see graph on the left). However trend-following systems tend to struggle in a directionless environment. They also may fail if markets fall or rise abruptly. February this year is a case in point.
So who can we depend on to provide an “honest” bid for equities?
Maybe retail investor sentiment will prevail. Consider this from Bloomberg’s Eric Balchunas, for instance:
The one-week ETF flows are basically a Who's Who in hot money faves when they looking to party. So much for the defensive/trade war/rising rates narrative.. pic.twitter.com/Uo619LzjgA
— Eric Balchunas (@EricBalchunas) July 10, 2018
In the same vein (i.e., in the context of “honest” sources of equity demand), what about plain old asset allocation shifts? Is there any scope for that?
According to the latest note from JPMorgan’s Nikolaos Panigirtzoglou, the answer is “no” – or at least “probably not”.
In a piece dated Friday (the latest installment of his popular “Flows And Liquidity” series), Panigirtzoglou begins by netting out the $30 trillion worth of tradable bonds owned by G4 central banks, reserve managers and G4 commercial banks. That’s more than 52% of the tradable global bond universe owned by banks, leaving 48% for everyone else, the lowest share on record. Here’s what that implies for asset allocations (and you’ll note that global M2 is included in these calculations to account for the cash balance of nonbank investors, such as households, corporations, pension funds, insurance companies and SWFs):
By excluding banks, i.e. entities that typically invest in bonds rather than equities, the amount of bonds held by the rest of the world, i.e. non-bank entities, is around $27tr unchanged from the end of 2016. This compares to $52tr of cash and $65tr of equities based on DataStream’s global equity index universe.
That is, non-bank investors, which invest in both bonds and equities, have an allocation to bonds of 19%, the lowest since the Lehman crisis (Figure 1). This 19% bond allocation is well below the 21% post Lehman average and slightly below the longer term historical average since 1999.
That, in turn, means that these same non-bank investors have an equity allocation of 45%, which JPMorgan reminds you is “well above both the 40% post Lehman average and the 43% longer term historical average”.
Here’s the implied cash allocation, which is below the two-decade mean:
The important takeaway here – and this is intuitive – is that while Figures 1 and 2 suggest that bond allocations could fall further to reach pre-Lehman troughs (and thus equity allocations could rise to hit pre-Lehman peaks), the unwind of central bank balance sheets makes that less likely, precisely because that unwind means the distortion (read: scarcity) of supply/demand in fixed income created by QE will begin to reverse. That reversal by definition means private investors will be called upon to absorb more bonds going forward. Here’s Panigirtzoglou one more time:
As G4 central banks are now on aggregate approaching a point where they will be reducing bond holdings, this unwind of QE means the non-bank private sector likely has to absorb more bonds, constraining the degree to which their bond allocations can continue to decline and, given already low cash allocations, how high equity allocations can rise. Given the structural changes in markets and economies in the post-Lehman environment, this suggests to us that post-Lehman period comparisons are more relevant.
Coming full circle, all of the above continues to raise questions about where the bid for equities will come from assuming i) the sugar high from fiscal stimulus fades (leading to slower earnings growth), ii) the buyback bonanza fizzles out and iii) sideways markets send ambiguous momentum signals.
Of course that’s a lot of assumptions (three of them, to be precise) so there’s a certain extent to which that’s a worst case scenario. But hey, if you’re not here for the worst case scenario, then why are you reading, right?