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The rally in global equity markets that started in June leaves many wondering whether it is just a bear market rally as excess positioning is squeezed out or something more fundamental. The most likely answer is that the market is getting increasingly confident it can map the shape of the coming slowdown and crucially the eventual recovery. Investors must pay attention though not to become overconfident on their abilities to assess monetary policies effects and future economic scenarios.
1. Why did equities rally?
The rally in global equity markets surprised many. Fear was rife of a coordinated recession in the US and Europe coupled with a sharp slowdown in China. There lockdowns combined with a real estate crisis left many to worry. As a consequence, investor sentiment reached extreme bearish levels (e.g. the Bofa/ML survey) and few market participants thought of it this time as a good counter-indicator signal.
Eventually, equities rallied from their June/July lows led by the US and Tech (e.g. Apple is close to historical highs). US consumer demand and the labor market were more robust than expected while earnings surprised on the upside. Fear of natural gas shortage in Europe over the winter subsidized somewhat and bullish speculation on oil ebbed pushing Brent prices lower supported by hope of an Iran deal.
Investor sentiment remained depressed in China amid signs of a cautious fiscal and monetary expansion. The reason lies in the excessive debt on the balance sheet of provincial governments and their potential projects are less appealing than they used to be. In a sense, China has done a large part of the heavy infrastructure investments it needs for the coming decade or so.
2. The outlook ahead
Fear of persistent inflation for the Fed and ECB have now given the equity market a pause. The market is left to oscillate between hope of less hawking monetary policies and worries that the economy is indeed slowing down.
Demand is holding well from mid to top tier consumers driven by market gains and a tight labor market. This should continue to surprise positively leaving the Federal Reserve to tighten monetary policy somewhat faster than is currently expected. The peak in Fed funds is in April 2023 at 3.7% and the odds are that we will get there much faster through 50/75bp rate hikes followed by a long pause as the Fed assesses the impact of its tightening and the anti-inflationary fiscal package. In such shocks are opportunities to build long equity positions at less expensive levels. CEO and household confidence should rebound and with it stock buybacks.
European central banks are behind the curve (less so in Norway) and the ECB’s Schnabel now points the way to a 50bp rate hike in September as the ECB continues its hawkish turn. In Europe, solid real estate and to a lesser extent equity gains and a robust labor market should support consumption. This contrast with a very gloomy German ZEW sentiment indicator on the back of a natural gas an China slowdown shock.
These upcoming shocks from tighter monetary policy should create entry points for companies that are both cheap and offer a quality of cash flows, listed infrastructure, ESG and real estate. We note two major issues in passive indices, namely a high concentration risk with Apple and the risk of an Iran deal which would send oil prices significantly lower, when this investment sector has sharply outperformed.