Too much of a good thing can eventually come at a cost.
Global Market Strategist
Among the myriad of investor concerns is whether equity markets are already pricing in all the good news, running ahead of the economic rebound and vulnerable to a pull-back. The risk is that once economic indicators start to miss expectations, then the “surprise” turns negative, and with it investor sentiment.
According to the May business surveys, the global economy is set to boom in the second quarter of this year. The overall Global Purchasing Managers’ Index (PMI) is at a record-high, as the already-elevated readings in the manufacturing sector are now combining with a surging services sector as mobility restrictions are eased in many parts of the world. This has been a Chinese and U.S. story to date, but Europe is now joining in. This should be good news for investors as it suggests that equity markets which are close to or above their all-time highs could still see further support from rising earnings expectations. However, the details of these business surveys also highlight several of the existing red flags for markets in the form of inflation pressures created by supply chain bottlenecks and difficulties in finding appropriately-skilled labor.
Alongside the PMI, the U.S. Institute for Supply Management manufacturing index (the ISM) is another widely used indicator for assessing U.S. and global economic momentum. In March, the ISM was at its highest level since the early 1980s, and while it has come down a little in the last two months, it is still one standard deviation above its long-run average. Historically, the ISM has not maintained that elevated position for very long, suggesting the potential for further falls in the ISM and possibly more moderate market returns.
Looking back to 1950, there have been 113 months when the ISM was one standard deviation above the average for the period. For each of those months, the average following three-month return on the S&P 500 was 0.3%. This includes periods when the ISM was both rising and falling. However. when considering only those times when the ISM was declining, the following three-month average equity market return becomes -1.0%. It should be noted that the average 12-month return in the U.S. equity market was positive (1.4%) even as the ISM was falling from its highs, as the ISM was often still above the key threshold of 50 after 12 months, indicating that the manufacturing sector was still expanding, even if it was at a slower pace.
EXHIBIT 1: DEVELOPED MARKET EQUITIES AND EARNINGS EXPECTATIONS
MSCI WORLD INDEX IN U.S. DOLLAR TERMS AND NEXT 12-MONTH EARNINGS EXPECTATIONS
However, while the U.S. ISM has some characteristics which make it useful in gauging economic activity and the market response, such as having a lengthy data history, frequent publication with few revisions and good correlation with the direction of real GDP, manufacturing represents a small share of the U.S. economy. This is pertinent given it was the services sector, a much larger share of U.S. GDP, that was hardest hit by the pandemic and the ensuing mobility and social distancing restrictions that were imposed. Even if manufacturing momentum was to moderate, it is likely that services sector activity will continue to rise until all restrictions are lifted. This could mean that markets are more resilient to changes in manufacturing-related surveys as the focus is on the rebounding services sector.
The MSCI World Index is 60% above its March 2020 low and 26% above where it ended 2019 prior to the pandemic. Equities are forward-looking and should move in advance of hard data releases such as GDP. However, even with the rebound in earnings expectations, the rally in equity markets has raised a few eyebrows (Exhibit 1). While a topping-out in forward-looking growth indicators is a factor to monitor, it is unlikely that that this alone would trigger a sharp correction in equities. However, when combined with prospects for higher bond yields, either from sticky inflation pressures or central bank tapering, it could certainly amplify investor anxiety.
Too much of a good thing can eventually come at a cost. A stronger economy and rising inflation prospects as well as an earnings recovery would make it difficult to justify negative real rates and the current positioning of many of the major central banks. Even so, such an outcome does not necessarily imply an end to the economic recovery or to longer-term bull run in global equities, but It could mean that returns at the headline index level are more muted in the near term.
Investors should expect bond yields to rise and equity market volatility to increase as it creates headwinds for growth-orientated sectors, or parts of the equity market that are very highly-priced. The ongoing recovery in the global economy only adds fuel to the underlying rotation in equities from growth to value and from the U.S. to Europe and rest of the world.