The Outlook for Equity Markets: update

by George Hatjoullis

On 21/12/2015 I published my first look forward into 2016 The Outlook for Equity Markets. The key paragraph is worth reproducing:

S&P 500

It is close to the all time high. The 21 day MA has crossed the 55 day MA downwards and is about to cross the 200 day MA. It is not a terribly negative outlook and the positions evidence is that sentiment is quite negative already. However, it is not positive either. The US dollar is strong and it is unclear why earnings should not continue to drift off. The Federal reserve is tightening, albeit slowly. There is evidence of stress in the credit markets. At best the volatile sideways path of  late 2015 should continue for the first half of 2016. At worst we could see a significant correction down to 1800. This still would be consistent with a long term bull market.

The worst has materialised and we have tested 1800 only to almost immediately bounce back to 2000. The long term bull market is still, in principle, intact. In practice, the situation is probably less comfortable than in December.

S&P 500 monthly

Even if the long term bull market is intact it is clear from the chart that the index could trade between 1800 and 2000 for the rest of the year before resuming the uptrend. Indeed this remains the most likely outcome. The problem is that if we approach 1800 investors may become fearful of a break in the long term uptrend. This could become self fulfilling.

There is reason to be fearful. Not specifically because of the condition of the US economy but rather because of the condition of the global economy and the worrying policy paralysis. Monetary policy has become at best impotent and at worse counter-productive, as I have argued in a recent blog Why negative interest rates will not cure deflation. The massed ranks of economists and pundits seem keen that the ECB cut deposit rates further. I rather think this make make matters worse and more important does not address the underlying problem.

The policy stance seems to be to reduce the stock of risk free assets in the hope that this will force investors into risky assets and stimulate economic activity. In practice it is merely raising the price of risk free assets. This serves no purpose and merely keeps portfolios biased towards risk free assets. If the policy stance were to shift in favour of more risk free assets being available it would lower their price and this dynamic might, perversely,  just shift portfolios in favour of risky assets. High yields may be attractive but rising yields not so much.

So what am I saying? Issue more government bonds, expand public spending and if possible use monetary financing of government spending. This will raise inflation expectations! None of this is going to happen of course, at least not this year. The deflation equilibrium that I discussed in the above blog looks set to take hold and in this environment holding cash remains logical. A breach of 1800 may occur despite the US economy displaying positive growth. Negative bond yields will not negate this risk but rather increase it.

There is one illusion that I should warn against (again) and this is US CPI inflation. National CPI indices are calculated on quite different bases. If you want to get some sort of consistency across national and regional economies use GDP deflators. There is a fairly consistent picture emerging from these data and this is no inflation anywhere.