Worldwide stock markets are riding on positive momentum in October. U.S stocks are at an eight-week high, Asia is on track for a third straight weekly advance led by a 9.8% jump in the Hong Kong stocks.

A Macquarie Equities Research (MER) research piece had most recently questioned whether equities are reflecting fundamentals…
 
Here are excerpts from the MER research report released on 8 October 2015:
 
Are equities reflecting fundamentals? Most leading and trade indicators seem to be highlighting that despite aggressive monetary easing by 20+ central banks, deflationary pressures remain strong and growth rates in both DMs and EMs are rapidly slowing. In response, fixed income, currencies and commodities (FICC) are signalling an elevated level of risk. However, equity investors seem to be assuming maintenance of ‘goldilocks’: low rates & ample liquidity; slow (but steady) growth and low (but positive) inflation.


Who is right? MER argues that most leading indicators have lost their informational value as private sector no longer has any long-term visibility, and hence survey-based responses frequently send misleading signals. Given that FICC investors tend to be intensive macro data users, they are highly susceptible to whiplashes of false signals. As long as public sector continues to dominate macro outcomes, FICC investors are at the mercy of unpredictable shifts, driven by central banks rather than fundamental drivers. Therefore, MER’s traditional assumption— that whenever there is a conflict between FICC and equities, the former is almost always right— might no longer hold, as FICC investors are now just as ‘blind’ as equity investors. Hence, equities just might be right.

However, MER is concerned on two counts: (a) global economy continues to reside on a de-facto US dollar standard and the US is not generating enough US dollars to enable continuing global leveraging (absent strong recovery or QE4, supply of US dollar is falling at around 5% clip); and (b) efficacy of conventional monetary policies seem to be largely exhausted. As global velocity of money declines, incremental QEs required to grow liquidity are on an ever increasing scale (around US$1.5trillion in 2016 and escalating to infinity). Hence, there is a need to re-assess nature of QEs. MER doubts that the alternative of central banks abandoning desire to regulate and ‘smooth cycles” and letting deflationary business cycle to reset itself is on the cards.

If conventional QEs lost potency and aggravate global deflationary pressures, why do equities assume that lack of tightening and further QEs would guide economies towards ‘goldilocks’? MER believes that it is a simple ‘Pavlovian reflex’. In the past, this relationship worked because QEs were generally successful in temporarily reducing deflationary pressures. However, short of massive rise in monetary stimulus, it seems that incremental changes would no longer be able to achieve such an outcome.

Are we ready for more extreme policies?

The next stage is likely to be central banks directly funding fiscal spending, investment and consumption. However, to accept such a radical shift requires ‘accidents’ and a severe slowdown. Over 12-18 months, chances of both are high but low over ST. Hence in the short-term (3-6 months), MER anticipates neither aggressive QEs (with at best limited efficacy) nor extreme unconventional policies.

Therefore, as investors progress into 2016, supply of US dollar is likely to continue contracting, deflating global demand and constraining liquidity. This would lead to regular bouts of volatility rather than goldilocks and could easily reverse current equity euphoria. Hence, MER is reluctant to back weaker emerging markets, and continue to play ‘safe’ by emphasizing countries with trapped local liquidity, some flexibility of monetary & fiscal policies and countries that do not excessively rely on commodities.

This continues to tilt MER towards India, China, Philippines and Taiwan and away from Indonesia, Malaysia and Thailand. MER also continues to emphasize their ‘Quality & Stability’ and ‘Sustainable Dividends’ portfolios. When would be the time for our ‘Anti-Quality’ portfolio? Probably sometime later in 2016-17.

Source: Macquarie Research - 16 Oct 2015