Four Reasons the Global Market Rally Should Be Viewed with Caution By Nicholas Spiro Premium Times, August 3, 2023

A trader works on the floor of the New York Stock Exchange on July 26, as a screen displays a news conference by Federal Reserve chairman Jerome Powell following the Fed rate announcement.

 

Four reasons the global market rally should be viewed with caution

The ferocity of the rally in financial markets over the past few months has been striking, despite persistent vulnerabilities and risks in the global economy While there are plausible reasons for the surge in optimism, high inflation in key economies and the possibility of a sharp downturn pose significant risks

Post A trader works on the floor of the New York Stock Exchange on July 26, as a screen displays a news conference by Federal Reserve chairman Jerome Powell following the Fed rate announcement. Photo: Reuters

If investors knew at the end of 2022 that, halfway through this year, global manufacturing activity would still be in contraction territory, US interest rates would be above 5 per cent, China’s post-Covid recovery would stall and leading central banks would be considering increasing borrowing costs further, would any fund manager have predicted that global stocks would be up 14 per cent this year?

That financial markets and the real economy often diverge, sometimes spectacularly so, should come as no surprise. What is striking, however, is the ferocity of the rally in the past few months in the face of persistent vulnerabilities and risks in the global economy.

The technology-heavy Nasdaq Composite index is up a staggering 33 per cent this year while spreads on US high-yield bonds have fallen to levels that precede the Federal Reserve’s decision in May last year to start raising rates aggressively.

There are several plausible explanations for the surge in optimism in markets. The most common one is that investors are increasingly confident the Fed can engineer a “soft landing” for the US economy by tightening monetary policy sufficiently to quell inflation without causing a recession.

In June, headline inflation fell to 3 per cent year on year, down from around 9 per cent a year ago. Moreover, the labour market remains remarkably resilient, with unemployment standing at a mere 3.6 per cent.

Another oft-cited reason is the euphoria around generative artificial intelligence (AI) following the release of ChatGPT, the most popular AI chatbot, last November. Many investors believe the consumer-friendly technology will unleash a productivity boom akin to the rapid growth of the internet.

This has turbocharged the rally in tech stocks, particularly the seven largest companies that account for nearly 30 per cent of the market value of the S&P 500 index.

However, there is a more compelling explanation. Investors have been blindsided yet again. The overwhelming consensus at the start of 2023 that the US economy would succumb to a recession this year and that equities – in particular tech stocks – would take a beating was emphatically wrong, resulting in a dramatic shift in sentiment.

Many investors who were unsure about the outlook for growth this year have turned bullish, while pessimists have become less pessimistic.

As JPMorgan aptly observed in a report published on July 20, investors had been “predisposed to the idea that the world [was] ‘bad’, with recession the endpoint for most client conversations. The reality is the outcome has been ‘less bad’ or maybe even ‘not too bad at all’.”

As is always the case in markets, expectations matter hugely. This is particularly apparent in Citigroup’s Economic Surprise Index, which measures the strength of economic data relative to market expectations, rather than the strength of the global economy. For the US, the index has soared to its highest level since early 2021, having been in negative territory as recently as May.

A customer shops during the reopening of the Century 21 flagship department store in New York on May 16. A key indicator of US inflation cooled in June to the lowest annual rate in over two years, although this remains above the central bank’s target. Photo: AFP

Put simply, sentiment has flipped in the space of just a couple of months. The burst of optimism, moreover, has been infectious, prompting many investors who feel they were unduly bearish earlier this year to look for reasons to be more sanguine.

This is why markets are downplaying risks and latching on to signs of resilience and recovery. They are also searching for silver linings. A good example is the reinterpretation of the inversion of the US Treasury yield curve, the traditional warning that a recession is imminent. Some investors believe the inversion says more about the sharp fall in inflation than it does about an impending recession.

Even in China, where growth has fallen far short of expectations and sentiment has deteriorated sharply, investors are clinging to the hope that additional stimulus will restore confidence in the economy despite persistent concerns about the timeliness and effectiveness of measures to boost growth.

Further pledges by Beijing over the past several weeks to jump-start the economy have lifted sentiment, despite the government’s reluctance to deploy large-scale fiscal stimulus. Bank of America – which dubs China’s policy easing the “great leap sideways” – said in a report published on July 27 that the support measures “reduce tail risk from banks/real estate, [and are] good enough to lift China domestic assets but not enough to lift China GDP.”

This shows that when expectations are low, even relatively modest improvements can brighten the outlook. Yet, while the surge in optimism makes sense, the pendulum of sentiment has swung too far in a bullish direction.

For starters, underlying, or core, inflation in the US and Europe remains sticky, suggesting further rate increases may be needed. Second, monetary policy takes time to play out. A soft landing could eventually turn into a harder one.

Third, policy tensions in China between supporting growth, restructuring the property market and preserving financial stability are only likely to become more acute.

Fourth, and perhaps most importantly, hidden vulnerabilities in the financial system – which have already surfaced in Britain’s pension industry and the US banking sector – are bound to deliver more shocks.

The global economy may not be in as bad a state as investors feared at the start of this year. But the factors that gave rise to those fears – high inflation and a sharp downturn – still pose significant risks. Some optimism is warranted, but not enough to justify such a ferocious rally.

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Nicholas Spiro is a partner at Lauressa Advisory, a specialist London-based real estate and macroeconomic advisory firm. He is an expert on advanced and emerging economies and a regular commentator on financial and macro-political developments.

Four reasons the global market rally should be viewed with caution | South China Morning Post (scmp.com)

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