After the sharp equity rally over the past four months, what could possibly drive another leg up? For me, the missing ingredient has been the lack of any upward re-pricing of growth.
This year’s equity rally has been like a calm ocean: it looks sunny and placid from the air, but has lots of changing currents beneath the surface. There have been two distinct stages to the rally so far:
Stage 1 was mainly a matter of pricing out recession and the market falls of late December. This did not require anything positive to happen, rather fears of the global economy sliding into recession became inconsistent with an absence of further negative newsflow. At the same time, the LGIM Economics Team began downgrading recession risk and a soft landing of the US economy has since become our base case.
Stage 2 was driven by the Fed’s dovish turn. At its late January meeting, Chair Jerome Powell shifted from ‘autopilot’ rate hikes to ‘patience’ and subsequently revealed a more relaxed attitude on inflation pressures.
Fewer future rate hikes for any given growth and inflation mix are generally good news for equities. The equity rally continued, but for different reasons to January. Market leadership flipped around from the day when the Fed dropped its hawkish bias.
Defensives in general and bond proxies in particular started to lead equities higher; a very unusual pattern, as these stocks are supposed to be low beta. But it is a pattern that's consistent with equity investors re-pricing to a more dovish Fed: good news for equities and particularly non-cyclical stocks with a high and safe yield.
Next up could be stage 3, pricing in more growth, arguably the most normal driver of rallies. Improving PMI data could trigger at least a part reversal of the cut to growth expectations that took place over the past six months. This could then return market leadership to the more typical high-beta cyclical sectors that have lagged in the rally so far.
We arguably saw a hint of what this could look like in early April. Cyclicals started to outperform on the day when IFO expectations ticked up for the first time, which was followed by the turn in China’s PMI data a couple of days later. The subsequent dip in PMI data and a return of trade war fears have stepped on any green shoots before they could flourish, but this can change again.
A growth-driven stage 3 should also help sentiment to turm outright bullish. Despite the strong rally, most of the sentiment indicators we track have remained in ‘cautiously optimistic’ territory. But if the best you can say about the environment is that we’re not heading for a recession and that the Fed has adopted a more dovish reaction function, perhaps we shouldn’t be surprised that equity investors aren’t feeling euphoric. More growth, however, sounds much more exciting to equity investors.
So we are holding onto our tactical equity long position for the time being. Should we see stage 3 play out and push sentiment to complete the cycle from fear to greed, it may be time to cut exposure.