Easter and Passover represent a time of reflection and a renewal of faith for many people. Investors will also welcome an opportunity for assessing equity and credit markets that have already notched impressive gains for the year.
Less than four months through the year, the S&P 500 including the reinvestment of dividends has returned to record territory, along with the technology sector and an index for chipmakers. Around the world, many benchmarks enjoy double-digit gains, led by China’s CSI 300 index, having risen more than a third already during 2019.
This leaves many institutional investors in a tough spot given their reluctance to dip their toes in the water a few months ago, no matter the abrupt market-friendly shift by central banks and an expansion in China’s credit growth that laid the ground for a rebound in activity, affirmed on Tuesday by first-quarter growth data that edged ahead of expectations.
This week, Larry Fink of BlackRock proclaimed that investors would fold and enter the market, citing “too much global pessimism” and adding that “there’s still a lot of money on the sidelines, and I think you’ll see investors put money back into equities”.
As the chief executive of the world’s largest asset manager, that’s hardly a surprising view, although fund flows do suggest that a shift from the sidelines in recent weeks has begun.
Any substantial shift in underweight investment portfolios likely entails further gains across equities, credit and emerging markets, setting the stage for one of Wall Street’s favourite outcomes, a “melt-up”, a steady climb in prices that sets new records and carries other markets along for the ride.
Given that many professional investors follow benchmarks and are judged on quarterly performance, there’s clearly pressure on those that have favoured cash and focused on a defensive posture in recent months.
This brings us to the fundamental issue for investors eyeing equities and credit at today’s levels. Namely, further appreciation in asset prices requires evidence of stronger and, more importantly, sustainable growth that extends the current business cycle and corporate earnings. Without that fundamental spur including higher global labour productivity that offsets margin pressure for companies, the extension of the 2019 recovery trade will enter dangerous territory as it diverges from a more challenging economic and earnings backdrop.
True, as spring finally seeks a claim here in the northern hemisphere, there are some economic green shoots emerging, with recent data in China and the US averting fears of a crunch in activity, a scenario that duly agitated investors back in January. That’s certainly a welcome development, but at this stage, the outlook for the global economy is one of moderation rather than acceleration.
In contrast, risk assets are humming, buoyed by expectations of a second-half recovery that validates the rebound in equities and credit since late December. Such a view rests heavily on a China-US trade deal arriving in due course and for Beijing’s stimulus spurring greater demand that ultimately pulls Europe and Japan along for the ride.
Fans of the melt-up scenario downplay discouraging factors such as faltering earnings growth and pressure on corporate margins. Or the idea that a more consumer-focused Chinese economy entails less demand for global commodity prices and trade than seen in the past. Indeed, China faces its slowest year of economic growth in three decades, while Beijing has indicated wariness about repeating its debt-fuelled stimulus as seen in the past.
Given the sustained rise in debt and leverage within China and across the global financial economy over the past decade, relying on another infusion of cheap money to fire up economic activity and justify rising asset values into the summer does look questionable.
And the growing use of debt shows little sign of abating thanks to the dovish turn by numerous central banks this year. Global debt sales are running at a record pace of $747bn according to data from Dealogic, eclipsing the prior high watermark of $734bn for the same time period in 2017.
This only heightens the sensitivity of market-risk appetite to a shock, such as a jump in bond yields or the rising price of oil with Brent crude seen challenging $80 a barrel as Opec maintains a tight leash on production and China stimulus hopes bolster sentiment for commodities.
Another brewing shock is faltering earnings over the course of the year. Notably, current interest coverage ratios for US companies are deteriorating against the backdrop of low yields and narrow spreads.
Marc Ostwald at ADM Investor Services notes, “even a modest rise in rates and/or spreads could prove very challenging, to say the least”.
With expectations of a second-half global recovery luring money off the sidelines, the principal risk for investors electing to chase the “melt-up” trade from here is that the US and China disappoint on the growth front as summer lapses into autumn.
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