LONDON (Reuters) - If bad
economic news continues to translate into good news for
investors, any sharp acceleration of the world economy
from here could well kill off the long-running equity
bull market.
While a mid-summer wobble in global markets was blamed variously on
anything from peripheral European bank woes to regional political
conflicts from Ukraine to the Middle East, it's the familiar "bad
news is good news" trope that's won out.
This seemingly perverse interpretation of negative or subpar
economic reports as a reason to buy both stocks as well as bonds has
been a feature of financial markets of recent years. So far this
year, shares on Wall Street and the 10-year Treasury bond are both
up 8 percent.
August has been no exception as dire second-quarter growth numbers
from Europe and Japan, poor Chinese loan and housing numbers and
underwhelming U.S. retail reports all combined to rally prices in
both stocks and bonds from recent lows.
On one level, the argument seems simple. With the world's central
banks committed to do "whatever it takes" to prevent deflation,
reboot credit growth and cut long-term unemployment, every
disappointment in incoming data merely boosts market hopes of fresh
monetary stimulus that lifts asset prices.
Or at the very least - as in the case of the United States or
Britain - underwhelming demand or inflation data argues against
early moves to raise interest rates sharply.
The finer points of that thinking are important, however.
If the world economy is flagging despite the huge amount of monetary
stimulus already applied over recent years, the prospect of ebbing
demand on the high street or on corporate order books should cast a
dark cloud over earnings expectations and already pricey equity
valuations.
But the transmission in practice is via bonds, where benchmark U.S.
and European government yields have confounded forecasters this year
and have fallen again on the back of rum economic reports on both
sides of the Atlantic and in Japan.
With long-term growth expectations ebbing, so too has the interest
rate horizon - and few now bet rates will return even close to
historical norms in the years ahead.
Instead of taking the economy's straight lead, stock markets follow
the bond. Sinking bond rates leave equity yields continuously
attractive for investors navigating between the two asset classes,
and that's captured by the still hefty "Equity Risk Premium" (ERP)
relative to historical averages.
"The discount rate matters a lot in the dividend discount model for
equities. At the extreme of zero percent interest rates, the
theoretical prices of equities could be infinite, or undefined,"
reckons Stephen Jen, who heads his own hedge fund. "This is the root
of the ‘bad-news-is-good-news’ and ‘good-news-is-bad-news’ notions
for equities, because yield curves matter so much."
"Equities may sell off, but I still think the most genuine trigger
is the Fed, not the Middle East or Russia."
WARY OF A BOOM
So if bad news is good news, so to speak, then should everyone now
be wary of any acceleration of the economy that hoovers up the
remaining spare capacity and sees jobs, wages and consumer price
growth pick up?
If rate rises by the Fed - or the Bank of England, European Central
Bank or Bank or Japan - are going to be the trigger to end this
five-year-old equity bull market, then presumably a build-up of
sparky economic data will be necessary to surprise investors already
braced for small, slow and gradual hikes.
"Markets just don't die of old age, they usually get killed off by a
shock," said Kerry Craig, global markets strategist at JPMorgan
Asset Management.
A monetary shock of that scale looks far fetched right now, with
global inflation near its lowest across the Group of Seven richest
countries in over 40 years. Craig at JPMAM, for example, reckons the
slow growth, low inflation and decent earnings story can persist for
much longer.
To be sure, geopolitics always has the potential to shock, but the
power of that punch to the economy usually needs an added factor
such as an oil price spike.
And despite the rampaging conflicts across the Middle East and
eastern Europe this year, that's just not happened. Crude markets
are sufficiently well supplied to see oil prices fall to their
lowest in over a year.
So what could juice up the economic numbers enough to force central
banks to reconsider their assumed monetary timelines?
The one big shoe that's not dropped in this recovery has been
capital and wage spending by companies, who've hoarded cash instead
for a variety of reasons related to their gloomy view of future
demand or higher pension and healthcare commitments.
An added fillip to the 'bad news is good news' idea for equities has
been that the absence of this confidence to invest in updating
businesses or rewarding staff has meant firms have opted for share
buybacks instead.
And so, long deemed the missing ingredient in the global recovery, a
significant capital expenditure revival could well be the trigger
for a stock market reversal.
The big risk for equity in this scenario is that a spur to growth
from any corporate switch to capex spending, recruitment and higher
wages away from share buybacks would not only lift bond yields and
cut the equity risk premium, but it could also potentially squeeze
margins and bottom lines.
"If you see wage growth come back, that could be one risk to
markets," said Stephen Cohen, chief investment strategist for
BlackRock International Fixed Income and iShares EMEA.
Good news is bad news indeed.
(Graphics by Vikram Subhedar. Editing by Susan Fenton)
While a mid-summer wobble in global markets was blamed variously on
anything from peripheral European bank woes to regional political
conflicts from Ukraine to the Middle East, it's the familiar "bad
news is good news" trope that's won out.
