Line chart of CSI 300 benchmark index of Shanghai and Shenzhen-listed shares showing Chinese stocks surge

Bullish sentiment flirts with a trap from peak surprises

The velocity of the current economic bounce is attracting plenty of attention with global equities flirting with breaking out of their month-long pattern of consolidation.

Forget central banks. Nothing spurs a bullish equity response quite like a Chinese editorial. The CSI 300 index of Shanghai- and Shenzhen-listed shares began the week with a surge of 5.7 per cent on hefty trading volumes after state media encouraged investors to go maximum bullish on a post-coronavirus economic boom.

Those with memories of 2014 and 2015 will recall that such cheer leading did not ultimately end well, a point made by the FT’s James Kynge. China’s 10-year bond yield rose 11 basis points on Monday and is back testing 3 per cent, a level previously seen in January before the benchmark tumbled below 2.5 per cent. Higher bond yields suggest an economic recovery gathering pace, but at some point the rise may check the enthusiasm for equities.

With European shares and Wall Street rallying on Monday (tech once more the big gainer, with shares in Amazon topping $3,000 for the first time), general market sentiment is clearly bullish. Recent outbreaks of Covid-19 are duly downplayed given the focus on reopening economies and the current trajectory of data.

John Vail, chief global strategist at Nikko Asset Management, notes:

“Despite all the troubles and potential risks, the solid upward equity market trend has been very hard to disrupt and investors and central banks seem happy to drive returns up more sharply than even we predicted.”

Global stocks peaked a month ago and have subsequently been churning within a fairly narrow range. During this period, economic data has been surpassing expectations, and affirmed the worst is behind us in macro terms. But in spite of the surprise factor, it has not been a catalyst for breaking the current trading ranges across markets. At least not yet.

As highlighted below, the Citi economic surprise indicator for the US has vaulted into record territory from its nadir in late April (with the ISM service sector data on Monday arriving well ahead of forecasts), carrying the bank’s global indicator along for quite a climb. Also shown in this chart, the surprise measure for Europe is recovering but remains below zero for now.

Line chart of Citigroup Economic Surprise Indices showing Beating expectations on the data front

Grounds for concern arise whenever markets fail to rally strongly on upbeat tidings. A common observation is that plenty of good news is already reflected in equity market valuations and from here the main concern among many is that the current news on the economy may well be as good as it gets.

Anna Stupnytska at Fidelity International expects a protracted economic recovery and thinks few countries return to their pre-crisis levels of activity by the end of next year. As shown here, Fidelity’s base case expects only the economies of China, India and Indonesia may end up being larger by the end of 2021 relative to the end of 2019.

“In our downside case, only China might grow bigger in this period.”

So perhaps there are grounds for the current surge in Chinese equities after all?

As for the US, some think the recent jump in Covid-19 cases muddies the economic outlook. Jan Hatzius at Goldman Sachs observes:

“Global GDP has now made up roughly half of the 17 per cent drop seen from mid-January to mid-April, with substantial gains almost everywhere. However, the sharp increase in confirmed coronavirus infections in the US has raised fears that the recovery might soon stall.”

The big question is whether the rise in US cases keeps consumers and business on the sidelines for longer. That raises the prospect of greater precautionary savings and weaker spending, clipping the wings of a forthcoming recovery.

Deutsche Bank observe that a focus on new cases entails slower economic activity “even if fatality rates turn out to be materially lower than in the first wave”.

More broadly, there is a sense that the initial phase of the recovery has played out. Neil Shearing at Capital Economics highlights that “even in those countries that manage to avoid new outbreaks, it is likely that the easy economic wins from lifting lockdowns have already happened”. 

Chart 1: Capital Economics Covid recovery trackers

Neil concludes:

“The bad news is that sustaining the pace of recovery will get increasingly difficult from here.”

So where does this leave equity market sentiment?

The global equity strategy team at Citi, led by Robert Buckland, caution global equities are likely stuck over the next 12 months and they advocate waiting for the next dip in prices, rather than chasing “markets higher from current levels”. The rationale for such a call is that forecast earnings from analysts are seen being 30 per cent too high.

“Our bearish top-down earnings forecasts suggest that global equities are more expensive than investors might think. For example, we think the MSCI AC World benchmark is currently trading on 24x likely 2021 EPS, not the 17x implied by consensus.”

Citi also highlight this important point:

“Before the lockdown, the MSCI AC World was trading on 15x 2021 forecasts.”

And equity sentiment faces a test in the coming weeks from quarterly earnings reports and notably from the outlook delivered by corporate leaders. Morgan Stanley Wealth Management thinks earnings could well emulate recent economic data, but they do add a cautionary note:

“Whether those surprises are good for markets will depend on companies’ forward guidance and if investors think the positive trends can be sustained.”

John at Nikko articulates a common view at the moment that “negative earnings guidance should drive CY21 EPS consensus estimates lower and, thus, tame markets”.

Quick Hits — What’s on the market’s radar

The fab four are back, or at least in terms of the $1tn market capitalisation club. Early in New York trading, Alphabet climbed to a market cap of $1.01tn and so joins Apple ($1.63tn), Microsoft ($1.60tn) and Amazon ($1.47tn) in the outer limits of the equity atmosphere. Contrarians may well look back at how the four tech titans previously entered this zone in January and then quickly lost altitude. Another sell signal?

The US dollar begins a new week on the retreat against most rivals and Deutsche Bank pinpoint the spate of recent outbreaks of Covid-19 across a number of states.

“As argued in recent weeks, the accelerating spread of the virus across large swaths of the US means that America’s economy is likely to lag Europe and north Asia in recovering from the pandemic. This underpins our bearish view on the US dollar.”

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