How rosy equities mask a wave of investor nerves

Watching financial markets at the moment triggers questions about the wisdom of the crowd.

Record-breaking equities appear at odds with the gloomy message from the bond market, with 10-year government bond yields loitering within sight of all-time lows. Sharply lower industrial metal and oil prices hardly paint a picture that a V-shaped global economic recovery beckons in the coming months.

The coronavirus outbreak has replaced last year’s rumbling trade war as the darkest storm cloud bearing down on markets. Investors can only wait to see whether a China growth scare takes hold from here, or whether this hurricane warning is downgraded to a passing bout of turbulence.

The divergent messages from different asset classes show how a fear trade feeds on itself and ultimately results in record highs in equities, led by quality and growth companies.

Meanwhile, quality companies with strong cash flows are a neat alternative for fund managers who are tired of government bonds’ meagre fixed rates of interest. Popular investment strategies such as risk parity, which combines both bonds and equities, intensify this phenomenon.

Passive investing flows also pump up the value of large companies compared with their smaller peers, as highlighted by higher returns generated since January and over the past year for the Nasdaq 100 and S&P 100 in contrast with their broader benchmarks. In effect, both government bonds and high-quality stocks are fear trades.

Alberto Gallo at Algebris Investments describes the present situation as one of investors “hiding in assets which benefit from central bank liquidity while shunning what depends on growth”.

That’s all well and good for investors who have enjoyed the ride up to now. But there is a long-term cost. Mr Gallo identifies how years of easy money from central banks have created a “winner-takes-all” climate.

“Large firms in a leadership position are able to tap cheap capital and can easily implement consolidation strategies and buy out their competitors. In turn, lower competition reduces economic dynamism and productivity,” Mr Gallo said.

These well-entrenched macro trends fan concerns that crowding further into a narrow cohort of quality and growth companies represents a financial stability accident waiting to happen. The longer bond yields remain stuck in the basement, the more that growth and quality stocks extend their rise. As investors are well aware, this is fine until it is not. The reckoning, whenever it comes, will be painful.

Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, worries that current market positioning “belies a cynicism about the ability of the Federal Reserve to reflate the economy and drive lasting improvements in the business cycle”. This, she argues, leaves investors “entering uncertain territory where only the cyclical stocks are valued for the risks of policy failure”.

With that in mind, aside from the health crisis here, which fund managers of course do not ignore, just how do China and other countries respond as the coronavirus growth shock fully registers in economies and markets in the coming weeks?

Given how unreliable leading equities benchmarks are as a gauge of global economic health, riskier and more macro sensitive assets, such as commodities and emerging-market currencies will probably offer a more useful guide. So far, rebounds in those markets have been rather more shallow.

One source of optimism is the hope that China and other countries across the region will deliver smart and vigorous packages of support. If they do, then mix in the soothing in trade tensions, and the hope that the virus subsides, and on paper at least, things look brighter.

Patrick Zweifel, chief economist at Pictet Asset Management, expects a V-shaped recovery in China after a first-quarter decline with tax cuts for sectors hurt by the coronavirus a likely policy response. That sets the stage for a rebound across emerging markets and a weaker US dollar as the year lengthens.

Such an outcome would hopefully provide a foundation for stronger capital expenditures and provides companies geared towards the economy with much needed leverage to boost their earnings growth and absorb higher input costs.

The alternative, and arguably more scary scenario, is that interest rates will be held “lower for longer” but they will support only an expensive niche of equities. That is not a comforting situation, for 2020 or beyond.

The longer this risk runs on, the more urgent it becomes for policy to deliver real-life results.

As Ms Shalett argues: “This is no longer ‘Goldilocks’. Either low rates and excess liquidity make their way into the real economy, driving an uptick in growth rates or cyclical stocks, or they feed an increasingly fragile and risky asset bubble.”

michael.mackenzie@ft.com

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