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Betting on the upturn

In early April the stock market cycle probably hit bottom. The Fed’s somewhat surprising inter-meeting rate cut in early Apri and subsequent further cut put an end to the fall in international stock markets. The European Central Bank’s surprise cut confirmed this, in our view. Since early April we have been placing our asset allocation bets on recovery.
The motive of the Fed rate cut on April 17 was mainly the worrying decline in capital spending and corporate earnings. These two factors have been the key for the US economy being able to maintain an exceptionally high growth rate in recent years. If the prerequisites for this are in danger the balance that has prevailed between consumption and productivity growth is broken and the economy is forced to a slower growth path. The Fed acts to safeguard that this balance is kept as intact as possible.
Compared to the situation in the beginning of the year, the US yield curve has turned in a stimulative direction. Investors are no longer paid for hiding in the money market. At the same time, risk aversion has diminished significantly, which has made it possible for corporations to return to the bond market in their financing needs. There has been a strong increase in new issues of corporate bonds. At the same time credit spreads have decreased, which is a strong sign of decreasing risk aversion and a positive signal for stock markets.
Stock markets and especially the US market have reacted positively since the beginning of April. In the US special factors like the taxation period ending on April 15 have helped to improve the balance between supply and demand in the stock market. Many households have been forced to sell off holdings to pay taxes from last year’s profit-taking in mutual funds and directly held stock portfolios. That is despite the fact that the market turned down sharply last year and during the first months this year. So households ought to have been downbeat when they lost on their holdings and having on top of that to pay turnover taxes. In April this ended and coincided with the lowering of the Fed funds rate. We believe these two factors have a great explanatory power for the turnaround of the US equity market since then. As a confirmation of more positive indications we also note in our quantitative models that the relation and interplay between volatility and price movements signal that new money is put in to the equity markets.
If we look to corporate earnings so far this year the results have in many cases come in a bit better than the markets expected – admittedly not good, but still better than what the markets priced in. This has also had a positive effect on the stock markets. Our quantitative models, before the turnaround in the markets, indicated that expectations were far too depressed and at a level where a reversal usually would take place. This eventually happened.
We can now count on all of the bigger central banks in the global economy being active to safeguard economic activity with policy stimulants. All will be driven by specific regional considerations and possibilities, but will still move in the right direction. From here it is a question of when and how strongly – rather than if – economic activity will pick up
A lot of focus is on the US. This is because the US is probably leading the rest of the world by at least six months – in the real economy as well as the stock market. We believe that we will see a pick up in activity in the real economy, very much due to the aggressive easing stance from the central bank. Already now we can see stabilisation in some of the leading indicators for the manufacturing sectors in the US. Europe will follow suit and then even Japan. Given the market’s discounting mechanism, this has implications for our asset allocation for the coming months.
We expect that the window of opportunity for a substantial overweight in equities is quite limited in time and that we not yet reached that point. However we have come to the conclusion that we at least should have a slight overweight in equities, but definitely having a clear underweight in bonds. The underweight for bonds is evenly divided between equities and cash, which both have a slight overweight in relation to benchmark weightings.
This allocation is also confirmed by our quantitative models, which are showing that the probability for stocks outperforming bonds/cash has recently risen substantially. At the same time has the probability for bonds outperforming cash been falling. On the whole, both the qualitative judgments as well as the quantitative models point in the same direction.
Pontus Bergekrans is head of asset allocation at Nordea Investment Management in Stockholm

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