Yesterday’s post cited improved investor sentiment as a reason for near-term caution on prospects for equities and other risk assets. A change in positioning as sentiment has shifted from excessive pessimism in late summer 2012 to moderate optimism now has been a key driver of recent market strength.
Equity hedge funds, in particular, now appear to have relatively high market exposure, suggesting that other investor groups will need to take up the baton if recent gains are to be extended. Exposure can be estimated by examining the sensitivity of the HFRX daily equity hedge return index to the MSCI World index. The beta measured over a 30-day rolling window rose from 0.13 in September 2012 to 0.48 last week – not far from a peak of 0.54 reached in June 2011 before a big decline in stocks.
The suggestion of bullish hedge fund positioning is supported by the latest Merrill Lynch survey, showing weighted net equity exposure of 45%, a seven-year high.
The indicators followed here were giving a positive signal for equities and other risk assets in late summer 2012:
Global real narrow money expansion was rising, suggesting an economic pick-up from late 2012 – see here.
A global “double-lead” indicator calculated here from OECD country leading indicator data had turned up, supporting the monetary forecast – here.
A large gap had opened up between global real money expansion and industrial output growth, implying “excess” liquidity available to flow into markets.
Central banks were easing policies and signalling more to come
Investors were unduly pessimistic about economic prospects and positioned defensively.
The current message from the same indicators is more ambiguous:
Global real money growth has moderated since late 2012 though remains at a level historically consistent with solid economic expansion.
The double-lead indicator has also declined – see below.
Global real money expansion remains above output growth but the gap has narrowed, suggesting a less favourable – but not unfavourable – liquidity backdrop.
Central banks are still easing but may scale back further stimulus in response to better economic news and market buoyancy.
Many but not all investors are optimistic and constructively positioned.
The judgement here, therefore, is that a reduction in exposure to equities and other risk assets is warranted currently and a shift to defence should be considered if the real money / output growth gap closes.
The global double-lead indicator fell further in March and is starting to diverge negatively from real money expansion – see chart. Real money has led recent industrial cycle turning points by an average of six months; the indicator has led by five months. The forecasting approach here places greater weight on monetary trends but both measures suggest that the acceleration phase of the cycle – during which equities typically do best – is ending.
Posts since last summer (e.g. here) argued that the Eurozone economy would bottom out in autumn 2012 and revive into 2013, based on a recovery in real narrow money from spring 2012. Economic improvement has been held back by an unwarranted appreciation of the euro – driven by US / Japanese devaluationist policies – but is now evident in industrial output data.
Output for the first quarter as a whole was up by 0.2% from the fourth quarter, while March’s reading was 1.4% above a trough reached in November. The six-month change has recovered to zero and should turn positive in April / May, rising further during the second half in lagged response to faster real money expansion – see chart.
Consistent with country-level monetary developments, the recovery to date has been led by Germany and the Netherlands, with output falling further in France, Italy and Spain in the first quarter.
As previously discussed, recent much-improved monetary trends across the periphery suggest a stabilisation in output in the second quarter followed by a second-half recovery. Germany should continue to lead the upswing but France should underperform and Dutch prospects have deteriorated.
Chinese monetary trends continue to suggest a dull economic outlook. Japanese trends suggest modest economic improvement.
Six-month growth in Chinese real narrow money M1 has been broadly stable since mid-2012 at slightly below the long-run average – see first chart. Weakness in 2011 and the first half of 2012 correctly foreshadowed a significant economic slowdown. Current growth is consistent with stable but slightly below-par economic expansion – in line with the official goal.
Chinese real broad money M2 is rising faster but, as in other countries, the narrow measure appears to be more closely correlated with future spending. The consensus focuses on M2 and credit measures, partly explaining recent overoptimism about economic prospects.
Six-month growth rates of Japanese real M1 and M3 have firmed over the past year but remain within recent historical ranges and are unexceptional by international standards – second chart. A significant further pick-up may be needed to support expectations of faster economic expansion implied by current stock prices.
UK quoted mortgage rates were little changed in April but rates offered on new fixed-rate bonds continued to plunge, according to Bank of England data released today. Banks, in other words, continue to widen margins.
Two-year fixed-rate bonds now offer only 1.90%, down from 3.24% in June 2012, just before the introduction of the funding for lending scheme. The decline of 1.34 percentage points (pp) compares with reductions of 1.00 and 0.87 pp in rates on two-year fixed-rate mortgages at 90% and 75% loan-to-value (LTV) respectively – see first chart.
Margins have also widened on floating-rate products. The average standard variable rate has actually risen by 0.12 pp since June 2012, even though banks are paying 0.57 pp less on instant-access deposits offering a bonus.
Wider bank margins are desirable to strengthen balance sheets and support future lending but the punishment being meted out to savers – with official approval – is brutal.
The second chart shows that a yawning gap has opened up between the dividend yield on the FTSE all-share index and the rate on two-year fixed-rate bonds. Retail buying of equity funds, unsurprisingly, has picked up, though currently remains modest: IMA figures show a net inflow of £3.8 billion in the six months to March, up from £800 million in the prior half-year.