A troubling preview of what’s ahead from Morgan Stanley’s chief cross-asset strategist Andrew Sheets.
What To Make Of It All?
There are still 240 trading days left in 2016, and plenty of questions that need answers. How bad is the global economy? Is oil the driver of markets or a convenient excuse? How much bad news is really in the price? What could realistically improve things, tactically or strategically?
Let’s start with what we know. Global growth is weak, and our 2016 GDP forecasts remain around 0.2pp below consensus in both DM and EM. But it is important to distinguish between below-trend growth (our forecast) and the recession fears gripping markets. While recent data have been poor, and financial conditions have tightened, a wide variety of indicators still lead us to believe that a US or global recession is not the base case. We will be closely watching US 4Q GDP, due to be released next Friday, which our tracking estimate places at just +0.1%.
If the growth outlook has moved less than the market, maybe the blame lies with oil? Brent was down 25% for the year through Wednesday, and the high correlation between oil and equity prices in this sell-off has implied a level of causation.
We are more sceptical. Falling oil isn’t the economic positive that many (including ourselves) assumed a year ago, but its decline looks more like a symptom of other issues (growth concerns, a lack of risk appetite, a stronger dollar) than the cause. The details of the equity decline also challenge the idea of oil driving markets; year-to-date, European healthcare is down almost as much as European energy. Japan equities, which have little energy exposure, have been a global underperformer.
So what is holding back risk appetite? A major overhang remains the question of how China will manage its currency. CNY is near the lower end of a range that has existed since August, a range our economists expect to hold through mid-year. But keeping the currency stable is being challenged by USD strength, and makes it more difficult for China to ease policy to support growth. We think this issue, above all others, is the main macro dilemma facing markets in 2016.
Could anything help? Look out for Wednesday’s FOMC meeting. Markets are concerned about both continued tightening and a US recession. They likely only need to worry about one. Were the Fed to remind the market that it remains data-dependent, it could temporarily alleviate some of the pressure on USD (and CNY), and address concerns regarding a policy mistake. We note that the rate market is already pricing in fewer than two hikes for all of this year. After a relative dovish ECB last Thursday, and with a BoJ meeting next Thursday-Friday, this could shape up as a big seven days for DM central banks.
Central banks won’t be the only things to watch between now and month-end. January has seen the largest monthly gap between stock and bond returns since October 2008 (around 11%). Any stock/bond allocation set at the start of 2016 is now off-benchmark as a result, raising the question of portfolio rebalancing flows. Given the c.US$36 trillion that sits in global pension mandates, even small adjustments could be meaningful.
Finally, some brief notes on valuations, especially in light of rising growth concerns. Global equities now trade on 13.5x forward earnings, near the 10-year median. Over the last 25 years, US equities have traded at a higher forward P/E 63% of the time, while EU equities have been more expensive 53% of the time. Longer-dated US BBB rated credit trades at +255bp. The average spread during a recession, going back to 1925, is +246bp. US high yield spreads averaged around 800bp over the 2001-02 US recession. They are already near these levels today. While valuations have improved across many assets, we think that credit is discounting the greatest risk of recession.
via Zero Hedge http://ift.tt/1PsppyT Tyler Durden