As FDR might say, the only thing markets appear to fear, is fear itself
Even Brexit has failing to trip up what for many has become the most-hated stock market rally ever
The FTSE All-World Index, a leading gauge of the world’s main stock markets, has surged 17 per cent since mid-February and is close to its record high set in May 2015.
More remarkably, most of the rally has occurred since Britain’s shock decision on June 23 to vote to leave the European Union (EU).
The strong gains in global equity markets have been driven by the dramatic rise of the benchmark US S&P 500 index which has shot up 19 per cent since mid-February and reached an all-time high last Friday.
Again, roughly half of the gains in the S&P 500 have occurred since the “Brexit” vote in a sign of the extent to which investors are brushing off concerns about the Europe-wide implications of the UK’s monumental decision to leave the EU.
Closely watched measures of volatility in equity markets, moreover, have fallen sharply.
The “Vix index”, Wall Street’s so-called “fear gauge” which measures the implied volatility of US shares, has plunged over the past six weeks.
Having surged to nearly 26 the day after the Brexit vote, the index has since dropped to 12 – only slightly higher than the pre-2008 financial crisis low of just below 10.
The calm in stock markets stems from what Convergex, a US brokerage, calls the “best of all possible worlds”. Last week’s stronger-than-expected US employment report has allayed fears about the strength of the world’s largest economy. However, just as importantly, bond investors are still betting that the Federal Reserve is unlikely to raise interest rates later this year.
According to Convergex, “the market still places a less than 50 per cent chance of a rate hike in 2016 and an 80 per cent chance that the Fed will move only once at most between now and July 2017.”
In short, investors appear to be are pricing in a “Goldilocks scenario” for the US economy: not too hot to fuel inflation and trigger a more hawkish response from the Fed, yet not too cold to fan concerns about the US falling into recession.
Yet this ideal scenario is not one which equity investors believe in with conviction – quite the opposite.
The most conspicuous characteristic of the current rally in global stock markets is the degree to which it is mistrusted by investors.
This is the mother of all unloved rallies.
A toxic combination of increasingly unattractive valuations (particularly in the US), weak corporate earnings, mounting concerns that central banks have “run out of ammunition” and, crucially, the plethora of political and economic risks the world over has been weighing heavily on sentiment.
Indeed global equity mutual funds have suffered large outflows this year, with European funds posting their largest redemptions on record last quarter and Japanese funds suffering their biggest outflows since the first quarter of 2008, according to EPFR, a financial data provider.
Even US equity funds suffered over $100bn in redemptions in the first-half of this year.
Credit Suisse, in a note at the end of last month, said “clients are close to being as bearish on equities as we can remember”, adding that they “do not find valuations attractive enough to compensate for the macro, political, earnings and business model risks”.
The ray of light, intriguingly, appears to be emerging markets (EMs) – the asset class that was most out of favour with investors up until quite recently.
Having suffered massive outflows over the past three years, EM equity mutual funds have been enjoying sizeable inflows since the Brexit vote, according to JP Morgan, with $5.5bn in the week between July 13 and 20 – the largest weekly inflow since early 2013.
The strong performance of EM stocks stems partly from the stabilisation of developing economies’ currencies, helped by a weaker dollar and a tentative recovery in oil prices.
Still, EM equities could quickly become just as unloved as their developed market peers.
If the Fed surprises markets by raising rates later this year, possibly as soon as next month, the dollar could start to strengthen again as investors reprice US monetary policy, undermining sentiment towards EMs.
However, with many government bond yields now in negative territory, equities look relatively more appealing to investors.
The most hated stock market rally could continue for some time yet.
Nicholas Spiro is a partner with Lauressa Advisory