The stock market is wobbly, overpriced, but likely headed higher
Expect the rally to continue for now, even as markets are showing more strain with each passing day
It has become an all-too familiar pattern in financial markets over the past few years.
First, there is the seemingly relentless rise in asset prices and persistently low levels of volatility. Then come the periodic bouts of anxiety over stretched valuations and investor complacency. Markets eventually suffer significant declines, fuelling speculation that a major correction is imminent. Yet no sooner does sentiment deteriorate than the selling pressure quickly abates, convincing international investors that every sell-off represents a buying opportunity.
Yet in the last few weeks, signs of a sharp correction have become more pronounced. In many corners of the market, there is growing nervousness.
Global equities are under strain, dragged down by a sell-off in commodities. European stocks, one of the most popular asset classes this year, have fallen nearly 4 per cent this month in the longest losing streak in a year while nearly 40 per cent of investors now hold a “short”, or underweight, position in United Kingdom shares - the highest proportion since the global financial crisis, according to a monthly survey of fund managers by Bank of America Merrill Lynch.
More worryingly, corporate debt markets - the frothiest part of the market - have suddenly become a focal point of investor concern. Money is being pulled from high-yield, or “junk”, bond funds at the fastest pace in two months, according to EPFR Global, a data provider. Spreads, or the risk premium, on junk bonds with the lowest credit rating, which account for over a third of the Bloomberg Global High Yield Corporate Bond Index, have shot up 40 basis points since the start of this month.
Emerging market assets, which have staged a dramatic rally this year, are also under pressure. Local currency bond funds are suffering outflows while several major emerging market currencies, including the Brazilian real, the Mexican peso and the South African rand, are under the cosh, partly because of the recent surge in the dollar, with the dollar index (a gauge of the greenback’s performance against a basket of other currencies) up 2.6 per cent since early September.
On Monday, Venezuela, which boasts the world’s largest oil reserves, was declared by Standard & Poor’s to be officially in default on its sovereign bonds in what is emerging as one of the messiest and most geo-politically contentious debt restructurings. Meanwhile, the deeply unpopular government of Brazil, an investor darling this year, appears to have thrown in the towel on much-needed pension reform just as political instability grips the Middle East.
As if all this were not troubling enough, bond markets have been sending worryingly mixed signals since the start of this year as the Treasury yield curve flattens. The spread, or gap, between the yields on 2-year and 10-year US government bonds has nearly halved to just 64 basis points - the lowest in a decade. While yields on short-term debt have shot up as the Federal Reserve turns more hawkish, yields on long-dated bonds have dropped sharply in part due to persistently low inflation. This increases the risk of a policy mistake by the Fed.
Put all these warning signs together and it is hardly surprising investors are on edge.
Fund managers themselves recognise that the rally has gone too far. According to the BAML survey, “a record high percentage of investors say equities [have become] overvalued [despite the fact] that cash levels are simultaneously falling, an indicator of irrational exuberance. Icarus is flying ever closer to the sun.”
Yet market signals are likely to keep flashing red for some time yet.
Firstly, the current bull market is the most unloved one in history. Not only are most investors aware of the risks and vulnerabilities in the global economy, they are longing for a correction - provided it is not a sharp and disorderly one - at a time when both bonds and equities have become far too expensive.
Secondly, according to JP Morgan, more than a fifth of the global stock of sovereign debt is negative-yielding, including nearly 40 per cent of euro zone debt. As long as government bond yields remain at ultra-low levels, investors will continue to seek out higher-yielding assets, buoying risk appetite and fuelling the rally.
Thirdly, and most importantly, while many investors believe the rally is overdone, they have never felt more positive about the outlook for the global economy, with a record high percentage of fund managers betting o “Goldilocks” conditions of strong growth and low inflation, according to the survey.
While markets are showing more strain with each passing day, the rally still has legs.
Nicholas Spiro is a partner at Lauressa Advisory