Climbing a great wall of worry

15th August 2012

 

After a brutal May, equity markets have quietly been enjoying a steady rise over the summer months. Initially led higher by the defensives, the rally has broadened of late with cyclicals taking up the running and stretching the lead of equities over other assets classes in the year to date. Since early June, the FTSE All Share has now advanced by over 12%. What makes this all the more impressive is that this has occurred in the face of a deteriorating global economy and the continued threat of a full blown Eurozone breakup.  

 

In what now seems like a scarily similar year to the previous two, optimism surrounding global economic growth at the turn of the year has slowly evaporated. Once again a knife has been taken to GDP forecasts, with the Eurozone and UK already slipping back into recession. Purchasing Manufacturing Indices (PMI’s) are pointing to a contraction in output, with the Eurozone unsurprisingly witnessing the sharpest decline. China’s manufacturing sector has now contracted for nine months in a row, whilst the last two ISM’s have highlighted even the US is not immune. Jobs growth remains subdued and whilst there are signs of stabilisation in the US housing market, it is hardly going gangbusters.

 

One could easily be forgiven for thinking risk assets would struggle in such an environment. So are equities burying their head in the sand or are they once again climbing a wall of worry and identifying a brighter future round the corner? Aggressive monetary easing has undoubtedly been hugely supportive to asset prices of late. China and the ECB have cut interest rates, the Bank of England has pulled the trigger on more QE and expectations of further money printing in the US are now firmly baked into markets. There are also signs that although undoubtedly weak, the economic data is beginning to stabilise. When is a 6.2% contraction in GDP taken as good news? Well, when it isn’t 7%. The better than expected Greek GDP figures in Q2 are irrelevant in the greater scheme of things but highlight that when expectations are severely depressed and investors positioning is deeply defensive, even apparently weak data can be viewed positively. More relevant is that global manufacturing PMI’s stabilised in August whilst services data actually improved. Similar to last year the recent fall in the oil price along with inventory rebuild, could give a notable boost to global GDP in the second half of the year.

 

Equity markets are traditionally optimistic and appear to be assuming further QE in the US is a certainty, the global economy escapes a serious slowdown and the Eurozone continues to muddle through. Bond markets, although arguably manipulated, suggest at least one if not more of these outcomes will fail to materialise. Who will be proved right only time will tell but given the bond markets track record the recent strength in equities may prove short lived.

 

John Husselbee