As bull markets go, the present one has been robust. Major equity indices have soared, in some cases at unprecedented rates, since the Covid-19 sell-off in Q2 2020. And before the pandemic shock, global equity markets had been on a central-bank driven roll since mid-2009.
Bull markets rarely end because of old age. Fatigue may result in a pause or even a minor correction, but not much more. Similarly, soaring valuations, alone, don’t end market advances. History suggests that even ageing bull markets need a catalyst to morph into bears.
Today, global equity markets are priced to perfection. But that isn’t really the fault of complacent investors. Given the alternatives, who can blame them? Yields across the spectrum of fixed income assets are paltry, in many cases below rates of inflation. Precious metals have done little this year. Other commodities initially advanced, only to fall back. Cryptocurrencies have been great, and then awful. More than anything, they are volatile. Adjusted for price movements, equities stand out as attractive.
Simply put, financial markets have not offered compelling alternatives to equities for a long time.
Nevertheless, this past week saw global equity markets drift lower. The declines, while not large, were nevertheless the biggest in several months. Is the ageing bull about to collapse?
Probably not, for reasons we outline below.
To begin, not much news prompted or accompanied the sell-off. The Delta-Covid-19 variant remains highly contagious, but areas hit earliest and hardest are beginning to see declines in infections. That is like what happened following earlier outbreaks in the UK or India.
Last week, the ECB also announced a tapering (of sorts), but stock and bond markets took the news in stride. Equity markets were already dipping before Friday’s surprisingly high US producer price inflation data.
Something else seems to be going on. Rather than reacting to poor data or news, investors appear to be pausing for reassessment. At the margin, active investors may simply be making minor adjustments to temper risk or take profits after an 18-month surge in share prices.
The underling narrative in markets has not changed. The consensus of observers is that inflation will be transitory, even if rising prices may persist for longer than central bankers have been indicating. Automaker production cutbacks, persistent reports of shipping delays at major ports, and Friday’s US inflation numbers provide more evidence that supply-chain bottlenecks and disruptions are not going to be as short-lived as earlier thought.
Yet at the same time, labor market tightness might ease. Declines in US weekly unemployment claims could indicate that expiring unemployment benefits will nudge reluctant workers back to the job market. But it is too early to say for sure. The last few employment reports offered mixed readings.
This week, investors will get a chance to pour over fresh data on the state of the global economy and inflation. China reports data on foreign direct investment, total social financing, retail sales and industrial production. The mainland data will say a lot about how domestic activity is unfolding in the world’s second largest national economy, as well as how Covid-19 related softness in global consumer spending and in shipping may be impacting Chinese economic activity. Capacity utilization, the Reuters Tankan survey and machine tool orders data will provide similar insights into the health of the Japanese economy.
In the US, industrial production, retail sales and Fed indices highlight the activity releases this week, but arguably core and headline consumer inflation (Tuesday) and the University of Michigan inflation expectations survey (Friday) will be most closely watched. Those reports will provide further information on the breadth and duration of US inflation outcomes and clues as to when Fed tapering might begin.
Returning to theme, equity markets are priced for benign outcomes. Investors believe that growth will not falter due to the pandemic. They may be right. As bad as the Delta variant is, it’s spread may soon peak. Moreover, the public health response to Covid-19 no longer includes damaging economic shutdowns. Investors expect that inflation, while running above central bank long-term targets, will not be so high (or persistent) to prompt aggressive monetary policy responses.
Those growth and inflation expectations are more likely to be right than wrong. The risks to the recovery from pandemic or monetary policy do not look more outsized today than they did a few weeks, or even a few months, ago.
It is undeniable that this bull market has been extraordinarily rapid and large. Given the absence of compelling investment alternatives, the size of consensus positioning is almost certainly extreme.
While bull markets don’t die of old age, they are vulnerable to exuberance, complacency, and positioning. Recent price action suggest that investors are growing more wary of technical, rather than fundamental, factors. That caution is worth heeding.
