Be wary of ‘equity euphoria’, turn to US dollar and gold

Analysts at Macquarie Research say the global stock markets rally is being fuelled by a rise in populism

PUBLISHED : Thursday, 23 February, 2017, 5:32pm
UPDATED : Thursday, 23 February, 2017, 10:58pm

The current investment fever gripping global equities is impressive, but investors need to exercise caution and focus on other safer assets like gold and the US dollar, analysts said. 

US stocks have soared since Donald Trump won the US elections on November 8. The “Trump rally”, largely based by many on hopes of massive fiscal expansion plans, has lifted US stock indices by more than 10 per cent in the past three and a half months.

On Wednesday night, the Dow Industrial Average hit a new all-time closing high, marking a ninth straight session of record closes. The last time it registered a record-setting stretch of the same length was in 1987.

Driven by the bullish sentiment in US equities and an influx of mainland capital inflows, Hong Kong stocks have also gained a strong momentum in the past few weeks.

By Thursday’s close, the Hang Seng Index had jumped more than 3 per cent this month. Trading volumes have also surged, with the daily turnover averaging HK$96 billion last week, dwarfing January’s HK$57 billion.

Morgan Stanley recently projected the Hang Seng Index to hit 31,000 by the end of this year in an uber-bullish scenario. That’s up nearly 30 per cent from the current level.

However, analysts at Macquarie are recommending a dose of caution within this equity “euphoria”, which they believe has been fuelled by an alarming rise of populism.

“Populist shifts lead to more extreme economic outcomes, usually implying a greater state role in directing economies, capital and investment, with equities initially staging ‘euphoric’ rallies,” said Viktor Shvets and Chetan Seth, analysts for Macquarie Research, in a recent report.

Prolonged periods of economic and social dislocation are usually reflected in politics, with relatively conventional political parties or leaders giving way to more radical solutions.

“While not as extreme, a similar process is playing out today,” Shvets and Seth said.

A variety of surveys, in the US, Europe, Russia, and China have indicated that it is the younger cohorts, including Millennials and later Generation Xers (those born between 1965 and 1981), that have a higher predisposition “to glorify strength and denigrate cumbersome and quite often corrupt democracies”, they said.

Unlike bond and forex markets which are preoccupied with downside, equities are moved much more by emotion and hope
Macquarie analysts Viktor Shvets and Chetan Seth

As in the medieval allegory of ‘Danse Macabre’ (or dance of death), there is “a remarkable resurrection in the reputation of leaders who while long dead seem to continue enticing the populace to dance towards the grave”, as shown by the rising popularity of Stalin in Russia, and an increasing number of Americans believing it is better to have a strong leader who does not need to bother with elections, Shvets and Seth said.

“US investors seem to be assuming fiscal benefits, cuts in taxes or regulatory reform – a sort of curious combination of former presidents [Ronald] Reagan (taxes and de-regulation) and Franklin D. Roosevelt (infrastructure investment).”

However, both Macquarie analysts think equity investors have underestimated the political, trade and deglobalisation risks, whilst over-anticipating the fiscal stimulus potential and the capacity to implement and fund such tax cuts.

The equity “euphoria”, they add, is a reflection of people’s hopes. But stock markets are usually poor at discounting major political and economic breaks.

“Unlike bond and forex markets which are preoccupied with downside, equities are moved much more by emotion and hope,” Shvets and Seth said.

For example, when Germany launched its Blitzkrieg (lightning war) against Poland, Denmark, Norway, and France between 1939 and 1940, the national euphoria “added about 15 per cent to German equities in 1940, in line with state-driven IP and rise in employment”, they said.

The same bullishness was evident in World War I.

After Archduke Franz Ferdinand of Austria was assassinated in June 1914, global equity markets didn’t signal any concerns and remained relatively flat to higher in 1914 and 1915. They only declined when the deflationary consequences of the war became more apparent in 1916.

Shvets and Seth suggest investors turn part of their focus to other safer assets, such as the US dollar and the gold.

In most cases of severe dislocation in the past, “smart money” went to gold and land, both traditional ways of protecting wealth.

Nowadays, they should go to “the same place as before”, they said.

The US dollar is also a good choice.

“It is a global medium of exchange, far more than even sterling was in the past. Until we devise a new monetary system, it is likely to remain the key store of value, ” they added.

“While tactical indicators currently signal potential US dollar weakness (overcrowded trade with high domestic policy uncertainty), global shortage of the US currency and its above described safety value still argues for a higher US dollar.”