Macro and geopolitical issues are key inputs into any market forecasting model. Today, we’re facing a period of prolonged uncertainty, such as when the peak of the interest rate cycle will be reached, and this, coupled with low volatility makes for an unusual combination and a difficult investment landscape. With fixed interest options also available, investment choices are much broader than they were just two years ago.
Despite all this doom and gloom, could there be some bright spots for equities investors? There are two competing views:
- Volatility, as measured by Axioma factor risk models as well as VIX, has fallen substantially. Lower volatility suggests investors should be more willing to buy stocks if all else remains equal. This is because the same return forecast has less risk or (to look at it another way), lower risk can justify a lower return expectation.
STOXX® Global 1800 – Predicted Risk
Source: Axioma, Equity Risk Monitor
- Volatility tends to increase in advance of a market peak, and we have not seen that occur yet.
- Trading volume has improved substantially.
- With the exception of in the UK, inflation in major economies appears to have peaked.
- Unemployment remains low and economies are still growing.
- as measured by our ROOF Scores (Risk-on/Risk-off)
The Bear case for equities
- The US market has risen on low volume and narrow breadth, suggesting a lack of real conviction, as investors focus on only a small number of names. In addition, the rally has largely been in the US and Japan. It is likely that many investors have not actually participated in the recent rally.
- US inflation may have peaked, but it will take several months of zero month-to-month growth to go back down to the Fed target of 2%.
- While an inverted yield curve generally predicts an upcoming recession, it has been this way for a year, so some are starting to question its value as a predictive tool. In this time period we’ve seen that both the markets and the economy can remain strong in the face of higher interest rates, but it is not clear whether that can continue forever: Rates remain high even at the long end, providing an attractive alternative for investors, and driving higher corporate financing costs. At the short end, rates are at 3-month highs, and can also be an attractive place for investors to keep their money until some uncertainties resolve.
Government Zero Coupon Yield Curves
Source: Axioma, Multi-Asset Class Risk Monitor
- Expectations for a rate cut by year end have evaporated and recent payroll data and employment figures are unlikely to change that.
- Valuations on the narrow segments of the market, which have been driving returns so far this year are getting stretched and a no earnings recession has been factored into forward EPS yet. Yield curves say a recession is coming but investors have yet to price that into their earnings forecast. At about 19x expected earnings for the full index, stocks are not cheap.
A look through the risk models
- Volatility remains low in every market, except in Japan where it started to rise back in May and is now raising a red flag for investors, especially after a 20% rally in stock prices. Meanwhile, over in China, volatility has just begun to rise again in June. Based on this metric, Japan and China score points with the Bears while the rest of the markets are chasing the Bulls. We note that in the US market, statistical risk models have been forecasting a rise in market risk, which is not corroborated by fundamental risk models but is still worth keeping an eye on, as it may signal an underlying risk not accounted for in the fundamental model variants.
- Additionally in the US, company-specific risk has started to become a bigger contributor to overall market risk, indicating that investors are demanding a smaller risk premium on the macro side of things and have started to evaluate companies on their own merits – good news for stock pickers in the US market. We are not yet observing this in other markets, so the macro outlook still drives overall risk in other markets. This is confirmed by a very low level of pairwise correlation among US stocks right now. Low correlation, high dispersion = positive environment for skilful stock pickers.
The main change from two years ago is the fact that investors have a choice between equities and fixed interest now. In other words, you can be paid to wait. The money that is in the stock market is already more risk-tolerant than the money that has come out of equities since the start of 2022. Equity investors are now ‘here to play’ and they are simply looking for reasons to buy and to spread their bets into other sectors.
During the summer, we can expect a sideways market, with pockets of rallies in different sectors and some profit taking in others, as investors switch from Big Tech to Industrials or Luxury Goods to Financials etc. But until this divergence between where the economy is and where it is expected to be is resolved, and some of the uncertainty around those major decisions around interest rates, inflation and energy prices are determined, we’re unlikely to see sentiment turn full-on bullish. This means that for now, markets are likely to take two steps forward and one step back, unless an event comes along to turn investor sentiment negative again, as we experienced most of last year.
In short, the best that can be said about the market rally in the first half of the year is that its manner cannot really support its mannerisms.