The US-China trade deal has been signed, the markets are bullish – what could go wrong this time?
- Despite the weak world economy and geopolitical stress, market sentiment is strong. But the bulls should be mindful that the US-China trade war has not been fully resolved and markets have become more vulnerable in the past year
The legendary investor John Templeton once described “this time is different” as the four most dangerous words in finance. The phrase, which is often uttered by overly optimistic investors near the peak of a bull market, is used to justify seemingly unsustainable gains in asset prices on the grounds that earlier tipping points in markets are a poor guide to current conditions.
Although US corporate earnings are expected to decline for a second straight quarter, valuations are becoming worryingly stretched. According to data from Bloomberg, the S&P 500 is now trading at the richest valuations since the bursting of the internet bubble in 2000, with the gauge’s forward price-to-earnings ratio – a popular valuation measure – surpassing the peak of the current bull market reached in January 2018.
Bonds are also trading at lofty levels. The yield on US speculative-grade, or “junk”, bonds has fallen to its lowest level in more than five years, according to the Financial Times, while the global stock of negative-yielding government and corporate debt stands at a staggering US$10 trillion.
The assumption on the part of investors that interest rates will remain lower for longer is helping propel stock markets to new highs, partly because the plunge in bond yields has allowed stocks to become attractively priced relative to bonds.
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In a note published last November, JPMorgan, while conceding that valuations had become stretched, argued that the most important reason to be cautiously optimistic about markets this year was “the lack of catalysts” for a major sell-off.
“Economies do not spontaneously succumb to their rather obvious vulnerabilities. They are nudged or shoved into recessions as tight monetary policy … and sometimes geopolitical stress … force overleveraged sectors to retrench,” it said.
Yet, although the Fed’s dovish U-turn is underpinning sentiment, markets have become more vulnerable over the past year. While trading conditions are indeed different today, some of these differences make a disorderly sell-off more, not less, likely.
Ironically, the biggest source of vulnerability is the one that is giving the bulls reasons to cheer. Having become more reliant on low bond yields to sustain high valuations, stock markets are now more exposed to tremors in fixed-income markets. Even a relatively modest uptick in bond yields – either due to an easing of trade tensions or stronger-than-expected economic data – could put equity markets under more strain than a year ago.
Another source of vulnerability is the continued weakness of the global economy. Although the recent batch of data suggests that the slowdown has bottomed out, growth remains lacklustre, with global manufacturing output barely expanding last month and persistent concerns about the health of the more resilient services sector.
Given the increasing optimism in markets about the global economy – a function of the excessive pessimism for most of last year – sentiment could deteriorate quickly in the absence of a meaningful improvement in the growth outlook in the coming months.
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Investors chanting “this time is different” would sound more convincing if the global economy was on a firmer footing. Yet, in a sign of the extent to which bond markets remain sceptical about growth, the yield on the benchmark 10-year US Treasury note fell even after the signing of the trade deal. This should give the bulls pause.
Nicholas Spiro is a partner at Lauressa Advisory
