Perspective - Managers' views
Are stock markets heading for a melt-up?
Equity markets have performed well so far this year, but there is now talk of a "meltup" with a number of investors arguing we will see a surge in indices in coming months.
Equity markets have performed well so far this year, but there is now talk of a "meltup" with a number of investors arguing we will see a surge in indices in coming months. Underlying this is the view that we are back in a "Goldilocks" environment where growth is "not too hot" to create inflation and "not too cold" to depress profits, it is "just right". The US Federal Reserve (Fed) is on hold, bond yields are low and investors have cash to put to work having missed out (apparently) on the rally in markets.
Certainly the Fed is playing its part following its dovish tilt earlier in the year which has led markets to dismiss the possibility of any further rate hikes in this cycle. The Fed can step back and markets can move higher. Inflation is a lagging indicator so low rates today do not mean low rates tomorrow. Nonetheless by starting at such levels there is a sizable cushion for the Fed to tolerate a pick-up in price pressures in the coming months and so allow it to be patient in determining interest rates.
More green shoots
On the growth side, there are also elements of Goldilocks. The US economy grew 3.2% in the first quarter, up from 2.2% at the end of last year and well ahead of expectations. The typical seasonal pattern of a weak Q1 does not seem to apply in 2019 and President Trump’s tweet highlighting the very low inflation is clearly a reminder to the Fed that it does not need to react with a rate hike.
Looking beyond the US, there are signs that China is responding to stimulus with a pick up in the purchasing managers' index (PMI) and our Schroders China activity index has also bounced. At this time of year, the data is heavily distorted by the Chinese New Year so we would resist calling a definite turn; nonetheless, leading indicators such as credit have also strengthened, suggesting that easier monetary policy and fiscal stimulus is working.
In Europe, the picture is more mixed, but here we also see signs of a turn with industrial production in Germany and across the region levelling out over the past three months while the manufacturing PMI's have bottomed out. Provisional Eurozone GDP came in at 0.4% in the first quarter, after just 0.1% in Q4. The one-off factors which depressed activity at the end of last year (tighter auto emissions standards, the gilets jaunes protests, low water levels in the Rhine, etc.) have faded, allowing growth to resume.
The recovery faces three headwinds
These developments reinforce the Goldilocks narrative and are welcome after the gloom which had engulfed markets at the end of last year. However, recovery still faces three headwinds.
First, there has been a large and temporary boost from inventory, not just in the UK, but across developed economies. The large build-up of inventories relative to activity and orders suggests that we will see a sharp cut back in inventory building in the current quarter, which will slow growth, unless underlying consumption and investment spending strengthen.
Another potential headwind to domestic demand is the rise in the oil price which has rebounded this year. This reflects a combination of the inventory building discussed above and the impact of the US ending sanctions waivers on purchases of Iranian oil. If sustained at current levels, oil will add to inflation later in the year. The risk to activity would be that consumer spending slows in response as real incomes are squeezed. Our forecasts for global activity are likely to move in a stag-flationary direction as a result.
The third headwind is from a potential profits squeeze. Whilst low inflation is seen as an essential part of the Goldilocks scenario, it also reflects a lack of pricing power amongst companies. Since both wage and energy costs are rising, this would imply a squeeze on profit margins. We expect US economic profits to rise 6% this year, but to fall 4% in 2020.
The prospect of a drop in profits does not bode well for the current proponents of a melt-up: like many before and since, the late 1990s bull market was led by healthy profits growth with gains in earnings per share accounting for a significant proportion of returns up to 1999. However, back then the final stages of the bull market were driven entirely by a re-rating, with the price-earnings ratio on the S&P500 rising significantly.
We may be right on the macro risks facing markets today, but the lesson from history would seem to be that melt-ups develop a dynamic of their own by sucking in investors who are fearful of missing out (FOMO). Any melt-up today would require the same – a FOMO mania.
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