Bad indicators abound. Globally, protectionism seems to be intensifying, and it’s bleeding into the real economy, undermining business confidence and investment. The global economic expansion is slowing down. The U.S. clearly isn’t immune, despite Donald Trump’s assertion that trade wars are easy to win. Monetary policymakers are busily scrambling to avert disaster. The European Central Bank unveiled a huge stimulus program in September; Federal Reserve chair Jay Powell is getting the Fed back into quantitative easing (which he is careful to stipulate isn’t quantitative easing ), and just about everyone expects another cut to the target interest rate later this month, with more to come. If the yield curve isn’t outright inverted — a classic recession sign — it’s as close as darnit is to swearing.
The global political mess isn’t helping calm fears. The U.S.-China trade war seems to be escalating, depending on which day you look at it. The impeachment investigation of Trump is only getting more contentious, and U.S. foreign policy seems to be becoming more unpredictable by the day. (As the Kurds can now attest.) As for the U.K. and Brexit, with an Oct. 31 deadline looming — well, let’s not even go there.
And yet, despite all this awfulness and uncertainty, the S&P 500 isn’t very far off its all-time high. Neither is the S&P/TSX composite. The EuroSTOXX 50, comprising the biggest and most liquid stocks in Europe — benighted, low-growth, recession-fearing Europe — is up nearly 16 per cent on the year; the smaller-cap STOXX Europe 600 is up nearly 13 per cent.
Has sentiment ever been so negative when markets have been so buoyant? Surely, something has got to give, right? And given the indicators flashing yellow or red lately, it’s safe to assume that the stock market is due for a comeuppance.
The thing, though, is this: “safe” doesn’t always turn out to be right. As much as there looks to be plenty of downside risk to equities, investors might want to be careful not to overreact to data or news and abandon equities altogether.
For instance, consider the U.S. manufacturing purchasing managers index for September, which came out at the start of this month. The PMI came in at 47.8 per cent — a sub-50-per-cent read for the second month in a row, suggesting that U.S. manufacturing activity was contracting. (Anything above 50 per cent indicates growth.) That is the lowest mark for the manu PMI since June 2009, at the tail end of the Great Recession. Meanwhile, the index for new manufacturing export orders was an even worse 41 per cent — the lowest level since March 2009, again marking a second straight month of decline.
It’s quite reasonable to infer from these numbers that the Trump trade war is starting to bite at home, and that it could very well bleed out beyond manufacturing and undermine the rest of the real economy. You could look at the immediate reaction of the stock market — the S&P 500 fell sharply after the PMI’s release — and conclude that at least some investors were getting the point by getting out.
And yet, it’s also reasonable to note the counterbalances to the gloom in this case. One is that employment and consumer spending (supported by low interest rates) remain very strong — and consumers account for about two-thirds of U.S. GDP. Another is that manufacturing now represents barely more than 10 per cent of U.S. economic activity. Manufacturing companies, however, represent more than 40 per cent of the S&P 500’s market capitalization, which helps to explain the post-PMI swoon in a way that doesn’t suggest widespread fear so much as tactical reallocations.
The point is, with so much uncertainty, downside risk might be getting too much play, and that might lead some investors to ignore upside risk.
So where’s the upside? Easy money. Low, low rates. Central bankers who will do anything to forestall a recession.
The continuing low-to-lower interest rate environment could do a few positive things for equity valuations. One is that as much as policy-watchers worry that central banks are pushing on a rope in hopes of stimulating economic activity, in the end it just might work. Monetary stimulus typically takes a while to kick in; it’s possible we’re just in the lag phase now, and come this time next year we’ll be talking about an earnings rebound rather than an earnings recession.
The other big point about low interest rates is that they create very few places — other than equities — for money to go if investors want to generate return. Fixed income? Yes, big investors will plow into government bonds for safety, especially with risk aversion running so high, but the returns will be low and, in a declining interest rate environment, seem bound to get lower. There is already more than US$17 trillion in negative yielding debt out there, and this dark-mirror pool is getting bigger – Greece just issued a three-month note at a negative yield.
Compare all that negativity with just the dividend yield of the S&P 500 — it’s almost two per cent, and it’s higher than the yield on a 20-year U.S. Treasury. In fact, low rates put a premium on dividend-paying equities, and many of those are blue chip companies in defensive sectors. So they might provide a hedge against a downturn while offering exposure to the upside in terms of yield. And on the earnings side, low rates support higher stock valuations — historically, anyway.
Of course, the global economy could still go completely pear-shaped and everyone will lose. But we don’t know what we don’t know. Even though things look gloomy, investors might regret it if they completely run for cover — the gloom might turn out to be a passing cloud.
Copyright Postmedia Network Inc., 2019