Everyone is nervous about what lies ahead. Yet everyone is also busily buying stocks.
If you would not have predicted this odd combination of pessimism and bullishness, join the club. Loading up on stocks carries obvious risks when Russia is waging a barbaric war, oil prices are levitating north of US$100 a barrel and central banks are jacking up interest rates to crush runaway inflation.
But bad news hasn’t prevented markets in both Canada and the United States from enjoying a nice rebound over the past two weeks. In fact, stock prices in both countries have recovered all their initial losses since Russia invaded Ukraine a month ago. They now stand higher than they did when the guns started firing – and that is despite rate hikes this month from both the Bank of Canada and the Federal Reserve.
Investors’ determination to buy the dip seems to be a continuation of the conflicting trends on display in this month’s global fund manager survey from Bank of America. The poll, which was conduced between March 4 and 10, covered 341 panelists with an aggregate US$1-trillion in assets under management. It showed a remarkable degree of negativity among these investment pros. The proportion of money managers expecting the economy to strengthen in the months ahead was at subterranean levels last seen in the financial crisis of 2008.
Yet all those pessimists on Bay Street and Wall Street weren’t giving up on stocks. Despite their expectations for a slowing economy, they remained slightly “overweight” equities – that is, holding higher than normal levels of shares in their portfolios.
What explains this strange loyalty to risky assets despite darkening economic prospects? Or the recent rebound in share prices? There are a few theories.
Pessimists can be bulls, too
Global fund managers continue to hold above-average levels
of stocks despite a rapidly darkening economic outlook.
Net % overweight
equities
Net % expecting
stronger economy
75
100
75
50
50
25
25
0
0
-25
-25
-50
-75
-50
2008
2010
2012
2014
2016
2018
2020
2022
the globe and mail, Source: bank of america
Pessimists can be bulls, too
Global fund managers continue to hold above-average levels
of stocks despite a rapidly darkening economic outlook.
Net % overweight
equities
Net % expecting
stronger economy
75
100
75
50
50
25
25
0
0
-25
-25
-50
-75
-50
2008
2010
2012
2014
2016
2018
2020
2022
the globe and mail, Source: bank of america
Pessimists can be bulls, too
Global fund managers continue to hold above-average levels
of stocks despite a rapidly darkening economic outlook.
Net % overweight equities
Net % expecting stronger economy
75
100
75
50
50
25
25
0
0
-25
-25
-50
-75
-50
2008
2010
2012
2014
2016
2018
2020
2022
the globe and mail, Source: bank of america
One line of argument says it’s not bullishness that is supporting stocks, but the lack of alternatives. Remember that bond prices move in the opposite direction to interest rates. Since central banks are likely to raise rates at a rapid clip over the next few months to put a lid on inflation, fixed-income investors face nearly certain headwinds. So maybe investors are staying loyal to stocks simply because they have no obvious place to run.
The problem with this theory is that rising interest rates don’t just hurt bonds. They also smack stocks by raising the cost of capital for companies, reducing the present value of future dividends and slowing the economy.
Furthermore, bonds have already taken a savage beating. At their current depressed prices, they incorporate expectations of rapid rate hikes ahead. On some measures, they are even starting to look attractive. A plain-vanilla 10-year government bond in Canada or the U.S. will now pay you substantially more in yield (2.5 per cent) than the S&P 500 will pay you in dividends (1.4 per cent).
At the very least, this suggests cautious investors have realistic alternatives to stocks. Yet stocks keep rising.
So maybe it’s time to consider other reasons for their advance. Another theory is that investors have recovered from the shock of Russia’s assault and are beginning to realize that, from a strictly economic perspective, things aren’t quite so dire as they initially appeared.
This makes some sense: Growth in both Canada and the U.S. is slowing, but still remains at healthy levels. Meanwhile, Canadian stocks, in particular, look reasonably valued, with shares selling for a mere 14 times their expected earnings over the next 12 months.
Unfortunately, this doesn’t necessarily mean clear skies ahead. Look at the U.S. yield curve. This measure of bond yields across varying maturities is flattening at a breakneck pace – that is, short-term bonds that mature in, say, two years are now paying nearly as much as bonds that mature in 10 years.
A flattening yield curve is often an early warning of bumps to come. When it inverts – when short-term bonds start paying more than longer-term bonds – a recession usually follows. Essentially, investors are saying they expect future interest rates to fall following the downturn to come.
So why are investors buying stocks today despite a rapidly flattening yield curve? This brings up the third and most robust theory about why stocks are rising: It’s all about timing.
Inverted yield curves are good at forecasting U.S. recessions, but lousy at forecasting when those recessions will set in. “Unfortunately, the yield curve, and especially the two- to 10-year portion that most people watch, doesn’t help a ton in determining the timing of recessions,” Roberto Perli, head of global policy at investment bank Piper Sandler, noted this week.
On average, the U.S. economy enters a recession 15 months after the 10-year-minus-two-year indicator inverts. However, recessions have started as soon as six months after an inversion has occurred and as long as a couple of years afterward.
Surprisingly, stocks have historically done well between the time a curve inverts and the time a recession hits. It’s not entirely clear why this happens. It may simply be a matter of investors refusing to leave the party until it is definitely over. Or it could owe something to people preferring the possibility of profits in stocks to the certainty of losses in bonds as rates rise.
Whatever the reason, the record is clear. Looking back at previous recessions, “it definitely doesn’t pay to be too pessimistic as soon as the curve inverts,” Mr. Perli said. For now, investors seem to be betting on this pattern continuing.
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