Rudi's View | Jun 27 2019
In this week's Weekly Insights (published in two parts):
-Crucial Question: Is It 1995 or 2007?
-Gold Stocks: Winners & Losers
-Rudi On Tour
Crucial Question: Is It 1995 or 2007?
By Rudi Filapek-Vandyck, Editor FNArena
Before reading this week's update on the global macro and equities picture, investors are advised to add three new words to their financial dictionary:
-Endcyclitis - the fear that the global economic cycle is about to turn for the worse
-ABC - Anything But Cash; primal, though logical response to exceptionally low interest rates; can be a specific strategy, a portfolio positioning, a necessity for survival, or simply an attitude
-Market melt up - when equities embark on a relentless rally to the upside; opposite of a melt-down
With equity markets in the USA, and now also in Australia, near all-time highs and with bond markets signalling central banks will be cutting interest rates (further) in the year ahead, it has become fashionable again to be bearish on the world, the global outlook and medium term prospects for risk assets; or make that for all assets, since central bank policies post-GFC are often casually summarised as "bubbles everywhere".
The general view is that while lower interest rates and low bond yields temporarily push up the valuation of assets such as listed equities, the day of reckoning will soon emerge on the horizon because this economic cycle is getting older and weaker by the day, and soon investor optimism shall be replaced by the general realisation that economies are about to fall into recession, and corporate earnings will collapse.
There are enough surveys and anecdotal observations out there to suggest this is now the mainstream fear across financial markets, with the general advice to investors being: make sure you keep on dancing close to the emergency exit door, or else.
Even RBA Governor Philip Lowe weighed in on the subject last week describing the combination of weakening economies, central banks cutting cash rates and rising equities as a "strange world" he fails to understand.
History shows, however, equity investors' attitude thus far in 2019 is far from irrational and despite general scepticism whether equity markets can continue to post further, sustainable gains, there are precedents to show the current set-up need not end in tears.
Economic recessions are not an unavoidable certainty. It is equally plausible that Fed intervention, assisted by other central banks around the world, can keep this economic cycle going for longer.
If this proves to be the case, equity markets can potentially rise a lot higher, even after the stellar returns already booked since the beginning of the calendar year.
Investors' anxiety can be traced back to two main factors: the US bond market is inverted, with yields on longer dated Treasuries below those on short maturities, plus the apparent high-level stand-off between Washington and Beijing.
The first is seen as an early signal that the US economy might be awaiting its first recession since 2008/09. The second is another negative impacting upon economies worldwide; if no solution can be found it significantly increases the chances for a global economic recession.
No wonder, investors worldwide have become increasingly wary and anxious, positioning their portfolios cautiously and defensively. This has led to the rather unusual situation that Citi's proprietary Euphoria-Panic Indicator (see Weekly Insights last week) is signalling financial markets were in Panic mode at a time when equity indices had been posting new record highs.
Usually when record highs are being posted, investor sentiment surges into Euphoria, while Citi's Indicator into Panic mode traditionally happens near market bottoms. So who's correct? Whom should investors trust as the best guide for the year ahead?
Interestingly, Citi economists themselves weighed in on the rather awkward Indicator contradiction this week. And their advice?
Trust the Indicator.
A Panic reading means equity indices are most likely set up for further rallies over the coming twelve months. Upon reviewing the 44 instances in the past when a similar Panic reading combined with a fresh 52-weeks high, equities rose in nearly 98% of those periods looking out twelve months, Citi reported this week.
Of course, there are no guarantees and research conducted by economists elsewhere has shown a direct and close relationship between the economic path forward and what investors can expect from their investments in equity markets in the year(s) ahead.
It turns out the proposition is rather binary: if we do end up with an economic recession, share markets will sell off, at some point, and potentially end up a whole lot lower. Think 2007 and 2001.
If we do escape the recession scenario, there will be more gains, and potentially quite large sized gains in the year ahead.
Macquarie analysts recently conducted their own historic analysis and their observations confirm all of the above. In eight of eleven Fed easing cycles since 1971, US equities ended up more than 10% higher one year after the first cut.
The three exceptions are 1981, 2001 and 2007. The joint commonality in all three cases is the ultimate arrival of the feared economic recession.
The prospects for Australian equities could be even better. On Macquarie's research, the All Ordinaries tends to rise by 12% in the year after the first Fed rate cut. And this time around the RBA is cutting too.