Just twelve short months ago, market sentiment was dominated by ‘tapering’. Bonds were being aggressively re-priced as investors raced to translate the latest comments from Ben Bernanke into a forecast for the 30-year rate of return on US sovereign debt; and equities were widely perceived as being the superior investment prospect, with the prevailing wisdom seeing the likely steady, gradual policy tightening as an endorsement of the same favourable growth picture that should reward the corporate sector and, correspondingly, equity investment.
By the middle of 2014 such beliefs had clearly changed quite a lot. It wasn’t that the market didn’t get what it had, apparently, been expecting: the actuality of ‘tapering’ and further evidence of economic growth. Indeed, by varying degrees, 2014 looked like a continuation of 2013 – in everything but price behaviour. So against what was a broadly unchanged backdrop, long-term US government bond yields rallied back to their pre-tapering levels (a capital gain of more than 20%) and, more recently, there have been sharp declines in equity prices – with markets falling by between 5% and 35% from their recent highs.
Prognostications of some imminent ‘correction’ in equity prices had certainly been in the air – seemingly on the basis that volatility had been low for ages and that couldn’t last. (This, incidentally, makes about as much sense as taking the view that interest rates must rise simply because they’ve been really low for ages.) Either way, the consensus of market commentators at that time was actually pretty sanguine about the prospect of a ‘correction’ – until it happened.
The most frequently used narrative now being used to justify the recent moves is that there has been some deterioration in the prospects for global growth. At the same time, apparently associated fears of deflation have resurfaced – specifically for the Euro Area but egged-on, coincidentally or otherwise, by a clutch of inflation data releases elsewhere coming in below market forecasts. If needed, further gloom can be found in weaker German trade data (on account of Russian sanctions, Chinese slowdown, or unusual weather, or, indeed, all three), weaker commodities prices, a stronger US dollar and, finally, the potential spread of the Ebola virus and its possible impact on travel, tourism, and economic activity in general. If the market wants to find reasons to be overly gloomy, there is never a shortage of material. This is also the case, of course, when optimism is the required emotion.
A kernel of truth always helps build a story. Inflation is indeed low and falling in quite a few economies. And the outlook for growth, especially in some European countries, remains challenged by structural rigidities, including a regulatory environment heading in the opposite direction. But in terms of the broader span of macro evidence, the balance of probabilities still weighs decidedly in favour of further expansion and improvement in most regions of the world.
The US economy is a case in point. Non-farm payroll data have been on an uninterrupted, improving trend for four years. This, incidentally, is a long time: already two months longer than the last cyclical upturn in the US labour market (between September 2003 and June 2007). Time, however, is the only variable by which the current expansion can be judged mature. The unemployment rate, at 6%, remains above its long run average and considerably higher than the stated desires of Federal Reserve officials. Indeed, ‘maximising employment’ is the mandated objective of the Fed.
Other labour market variables are still more indicative of early-stage expansion. After an unconvincing start, household income seems finally to be responding to the improved job situation (see figure 1) and a further important point to make in this regard is the favourable impact on real incomes that can be expected both from the recent declines in the oil price and from the further falls in mortgage rates (see figures 2 & 3).
Looking more broadly, global labour market indicators have improved over the past twelve months, with falling unemployment rates reflecting the improved underlying demand picture that has been in evidence from a variety of indicators such as the Purchasing Managers’ Indices (see figures 4 & 5).
To be sure, joblessness remains high in many regions but the direction of change is clear – and with central bank policy having an acute sensitivity to downside growth risks (as further evidenced last week by Andy Haldane and James Bullard providing very prompt reassurance in this regard – see the links at the end of the piece) the supportive tailwinds behind on-going expansion seem likely to continue to outweigh structural headwinds.
Amid a general environment of improving, but unspectacular demand growth – a world of lower numbers – an overly enthusiastic desire to analyse, and draw profound conclusions from, monthly variations in economic data series can, to a greater than usual extent, be a complete waste of time.
From an investment perspective, equity valuations just got a great deal more attractive while many of the facts supporting those valuations remained broadly unchanged. In that regard, the market’s recent moves render equities, and some areas of the corporate bond market, a more attractive – and, importantly, less risky – prospect than developed market government bonds, which again look a tad expensive.