Don’t panic Mr Manwaring, stupid boy Pike

Global equities take a not totally unexpected knock after the release of the minutes from the June Fed meeting, which effectively confirmed we are at the start of the next Fed tightening cycle. US treasuries remain in demand in the “risk-off” mood as longer-dated yields fell further. We have commented on the strength in bonds in the past few months, despite inflation and growth rates exceeding forecasts, and questioned why? Is the bond market sending the equity market a message about growth expectations?

As we enter the second half of the year, we may see some slowing in economic growth at a time we enter a period of reduced liquidity due to higher taxation and reduced stimulus from the Federal Reserve. Should this combination lead to economists becoming more cautious on the outlook for economic growth, stock analysts will become more cautious on earnings.

Another short term factor is possibly affecting stocks. As Nomura announced yesterday, in the aftermath of the Archegos collapse, they will no longer offer prime brokerage services to hedge funds. Managers using Nomura’s balance sheet to fund their strategies will need a new prime broker. Some will struggle, but all will most likely be forced to reduce their exposure whilst they make arrangements. 

After such a strong recovery, some resetting of expectations is to be expected. Should this derail the equity story? On the negative side, US equities look expensive, as is regularly commented upon, as well most sentiment indicators show extreme levels of optimism for stocks, reflected in strong equity inflows recently. There are signs that this equity optimism has led to more leverage towards stocks being used. All these indicators point to a correction. Falling yields are a double-edged sword for equity markets. On the one hand, they make equities look more attractive. On the other, it suggests a level of concern on the growth outlook.

On the plus side, the world is in a much better place economically than it has been since 2008. Banks balance sheets are a lot stronger than they were. Saving rates amongst homes has improved as a result of the pandemic. We are better prepared for any downturns.

 Stocks rise during periods of economic growth and fall during economic recessions. There are times when equity indexes, just like individual stocks, overprice those growth expectations and get ahead of themselves. This may be that time.

We had witnessed on several occasions ever since the world’s central bankers rode in over the hill to support the banks in 2008, periods of additional volatility whenever the Federal Reserve looked to take its foot off the monetary gas pedal.

The reset button may be about to be hit, adding volatility and testing the nerves in the short term if growth expectations are moderated. Whilst the global economy is expected to grow in the coming year, equities should remain supported and the panic button avoided.