Optimism & pessimism – ultimately more QE is key

We’re due the preliminary January reading for the US University of Michigan consumer sentiment indicator today and the consensus forecast is for 71.5 – consistent with buoyant conditions, and up from 69.9 in December. Some commentators are expecting more and recent strong data have been supporting risk assets. But recent strength in US data has pushed the US data surprise index to pre-Lehman highs, and this should dampen the chance that US data further support an expansion of investor risk appetite in the coming weeks.

More worryingly, there’s the gnawing concern that the strength of the US economy in recent months has been an outlier, as growth rates have weakened almost everywhere else and it’s reasonable to expect US growth rates to revert to a more moderate pace over the next six to nine months because underlying conditions in the US don’t differ fundamentally from those that exist throughout the debtor developed world, and nor is the US immune to the broader slowdown in global growth triggered by the deterioration in global financial conditions.  As a point of detail, much of the recent acceleration in the US economy has come from household demand, which has supported both production and employment, yet this spurt in household spending has been financed by a steep decline in the savings rates and not through income growth, which remains depressed due to weak wage growth. Given still weak US household balance sheets and the recent deterioration in global financial conditions, we should not expect household savings rates to continue to decline as fast as they have been.

So it’s easy to be nervous, but the facts are presently that US economic data continue to surprise on the upside, and lead indicators are now consistent with GDP growth of 3.3%, compared with a current consensus forecast of 2.1%. This means that we must acknowledge the scope for sustained better than expected news and strong risk asset pricing not least because equities are c20% cheap against expensive bonds. On a forward looking basis, the US equity risk premium is presently around 6.5%, while taking account of current credit spreads and the ISM survey readings the warranted risk premium is 5.3%. Furthermore, the ratio of equity to bond returns is currently at around a 30-year low, and we have been through the biggest drawdown since the middle of the nineteenth century. As for ‘risk’, the more government credit quality is questioned, the more equities with a high credit rating may be seen as a cheap lower-risk option.

The corporate background can be construed as helpful: US earnings momentum appears to have troughed and historically a trough in earnings momentum sees equities rising by 7%, even if earnings are still being revised down.

Of course there are considerable risks but arguably markets have been preoccupied with downside risk. Indeed, in the Year Ahead poll of 83 economists covered in the FT on 2 January, a fifth (17) of respondents thought the Euro would break, while only slightly more than half (43) thought the monetary union would survive the year in its present form. This worried mindset is reflected in fund flows and EPFR report that inflows into money market funds are now at the highest that they have been since March 2009.

Given negative sentiment, there is scope for an upside surprise and arguably ‘tail risks’ are falling. Chinese money supply growth has re-accelerated, after falling to the lowest level in a decade in October and the ECB has been active with 3-year LTROs. Perhaps more importantly, the real catalyst for a stronger-than-expected rise in equity markets would be significant additional QE, involving the MPC, the Fed, the ECB, and the Bank of Japan. Part of this liquidity may just go into equities. After all, investors should be concerned that raising the money supply now boosts inflation in 3 to 10 years time, and markets seek to price the future. Meanwhile, global excess liquidity is rising strongly, consistent with a 5% re-rating, and this is before any more QE.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla