It is too early to say if the rally on global stock markets, which began in early July, is over. In recent days it has certainly lost momentum, on fear of higher US interest rates than previously expected and on weak economic data from the Eurozone and China.
A period of consolidation would be welcome, while we wait to see the impact of the coming global economic slowdown on corporate earnings.
It’s a strange (macroeconomic) world:
Economists are looking at recent economic data and scratching their heads. The current strength of labour markets in much of the developed world, against a background of weak (or no) economic growth, defies the Keynesian economic models that they learned at school.
Investors, meanwhile, are paying less attention as to why the models are broken and more to the implication. For them, strong labour markets mean that underlying demand may remain strong as Central Banks remove excess demand with higher interest rates. This would suggest only a limited hit to corporate revenues.
Recent second quarter corporate earnings announcements in the U.S. appear to bear out this optimism. Top-line revenue has not weakened as much as might have been expected, given the sharp rise in interest rates this year.
July’s U.K retail sales data showed (unexpected) growth over June, despite weak consumer confidence amid a ‘cost of living’ crisis.
The result may be a shallower-than-expected recession in the U.S and relatively shallow albeit prolonged in the U.K and Eurozone, due in part to Europe’s greater sensitivity to energy prices than the U.S. The Bank of England is expecting five consecutive quarters of falling output in the U.K economy, but the dips to be less severe than those seen in the recession that followed the financial crisis and during the Covid pandemic.
This analysis helps explain why risk assets have had a strong rally since early July, with renewed interest in growth sectors such as technology stocks.
Time will tell if this optimistic view proves correct. And, of course, there are plenty of counterarguments being expressed.
Some economists maintain that surprisingly strong recent U.K retail sales and U.S labour markets data are lagging indicators. That these will correct as weaker spending by households and businesses, together with the rising cost of borrowing, impact on spending and hiring.
This argument holds that the Keynesian model is still basically intact. But it looks thinner the longer the contradictory economic data persists.
Another explanation for the recent global stock market recovery is that it has been driven by hedge funds, covering their short positions. Long-only funds have not been particularly active, suggesting to some that confidence has not really returned to risk assets.
This argument, put forward by several large U.S. investment banks in recent weeks, is based on irrefutable data on who is buying and who is selling.
It is, though, less a refutation of the rally than it at first seems. After all, which type of investor is most sensitive to an improving investment climate? The long-only, or the leveraged bear who has shorted the market and who is vulnerable to outsized losses if stock markets pick up?
It is perfectly rational to see the bears be the first to respond to improving investment conditions, and to look to cover their short positions.
Investors should remain diversified:
The S&P500 is now down just 10% from its all-time high, as against over 20% at the end of July. A period of consolidation would be welcome while we wait to see if global inflation does indeed roll over this autumn as predicted, allowing Central Banks to ease up on their monetary tightening. If wage growth can be managed down, through a rise in unemployment and weaker demand, without widespread redundancies occurring, both Central Banks and investors will be pleased.
But we are not there yet. The current inflation cycle has been longer, and more severe, than anyone expected. It may continue to be so. Meanwhile, the long-term impact of central banks’ monetary tightening on the economy, and on valuations of risk assets, is unclear.
Investors should remain cautious, and diversified across asset classes, geographies, and currencies.
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