Short And Sharp: Short And Shallow, Actually

Summary

Last week, global equity markets sank in response to the European Central Bank decision to extend its forward guidance and announce new liquidity operations.

Since late December - despite a backdrop of weakening economic activity in the U.S., China, and Europe - equity markets have enjoyed a V-shaped recovery globally, leaving risk assets ripe for disappointment.

But with Chinese credit data continuing to weaken, and PMI data showing a worrying decline in global manufacturing activity, the market rally seems due to run out of steam and may even shift into correction mode in the coming months.

By Seema Shah, Global Investment Strategist, Principal Global Investors

Typically, when a central bank eases monetary conditions, risk assets rally. Last week, however, global equity markets sank in response to the European Central Bank (ECB) decision to extend its forward guidance and announce new liquidity operations.

Any positive impact from the more dovish interest rate outlook and support for the banking system was swiftly swamped by concerns about the ECB’s significant downward revisions to its growth and inflation forecasts.

Such a market response was, if anything, overdue. Since late December - despite a backdrop of weakening economic activity in the U.S., China, and Europe - equity markets have enjoyed a V-shaped recovery globally, leaving risk assets ripe for disappointment.

Undeniably, the strong market performance has been propelled by fundamental dovish shifts in the Federal Reserve’s reaction function and progress in U.S./China negotiations. Yet, those factors are one-time-only energy boosts for risk assets. They can’t continue to prop up the markets unless accompanied by a strengthening economic backdrop.

Admittedly, global equities bounced back this week. But with Chinese credit data continuing to weaken, and PMI data showing a worrying decline in global manufacturing activity, the market rally seems due to run out of steam and may even shift into correction mode in the coming months.

So, how far could U.S. equities fall?

Although the fundamentals are concerning, I don’t expect a recession. I envision global growth picking up later this year as Chinese growth stabilizes. Market technicals and valuations aren’t frantically ringing alarm bells. U.S. equities aren’t overbought - in fact, flow data suggests that many hedge funds didn’t participate in the equity market upturn in Q1, instead cautiously remaining on the sidelines. With earnings forecasts already significantly downgraded, not only should any equity sell-off be short-lived, it’s likely to be modest.

Emerging markets (EM) have increasingly become a crowded trade, rendering it vulnerable to a sharp shift in global sentiment and a strengthening of the U.S. dollar. The greenback tends to be countercyclical to global growth, and last week’s downbeat ECB growth forecasts pushed it to new highs for the year, spurring greater risk aversion toward EM.

How should investors position in this late-cycle environment? Any attempt to perfectly time a turning point is a thankless task - particularly when correction is likely to be short and shallow. With no recession on the horizon, investors should remain overweight risk assets but pivot toward a higher-quality, shorter-duration, and more defensive allocation. Emerging markets can continue to outperform, but investors need to be selective, favouring sovereigns which are anchored by strong reserves. Active management, global diversification, and a focus on strong balance sheets, wide profit margins, and stable returns - these are key during late cycles.

Finally, a word of caution. My expectation for a short, modest correction is based on a global recovery later in 2019 - and China is at the forefront of that story. Anything that weakens China’s outlook will only serve to awaken the fear that simmers just under the market’s surface.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.