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'Good news' shock could kill the five-year-old bull market
August 20, 2014 / 7:21 AM / 3 years ago

'Good news' shock could kill the five-year-old bull market

LONDON (Reuters) - If bad economic news continues to translate into good news for investors, any sharp acceleration of the world economy from here could well kill off the long-running equity bull market.

Traders work on the floor of the New York Stock Exchange August 19, 2014. REUTERS/Brendan McDermid

While a mid-summer wobble in global markets was blamed variously on anything from peripheral European bank woes to regional political conflicts from Ukraine to the Middle East, it’s the familiar “bad news is good news” trope that’s won out.

This seemingly perverse interpretation of negative or subpar economic reports as a reason to buy both stocks as well as bonds has been a feature of financial markets of recent years. So far this year, shares on Wall Street and the 10-year Treasury bond are both up 8 percent.

August has been no exception as dire second-quarter growth numbers from Europe and Japan, poor Chinese loan and housing numbers and underwhelming U.S. retail reports all combined to rally prices in both stocks and bonds from recent lows.

On one level, the argument seems simple. With the world’s central banks committed to do “whatever it takes” to prevent deflation, reboot credit growth and cut long-term unemployment, every disappointment in incoming data merely boosts market hopes of fresh monetary stimulus that lifts asset prices.

Or at the very least - as in the case of the United States or Britain - underwhelming demand or inflation data argues against early moves to raise interest rates sharply.

The finer points of that thinking are important, however.

If the world economy is flagging despite the huge amount of monetary stimulus already applied over recent years, the prospect of ebbing demand on the high street or on corporate order books should cast a dark cloud over earnings expectations and already pricey equity valuations.

But the transmission in practice is via bonds, where benchmark U.S. and European government yields have confounded forecasters this year and have fallen again on the back of rum economic reports on both sides of the Atlantic and in Japan.

With long-term growth expectations ebbing, so too has the interest rate horizon - and few now bet rates will return even close to historical norms in the years ahead.

Instead of taking the economy’s straight lead, stock markets follow the bond. Sinking bond rates leave equity yields continuously attractive for investors navigating between the two asset classes, and that’s captured by the still hefty “Equity Risk Premium” (ERP) relative to historical averages.

“The discount rate matters a lot in the dividend discount model for equities. At the extreme of zero percent interest rates, the theoretical prices of equities could be infinite, or undefined,” reckons Stephen Jen, who heads his own hedge fund. “This is the root of the ‘bad-news-is-good-news’ and ‘good-news-is-bad-news’ notions for equities, because yield curves matter so much.”

“Equities may sell off, but I still think the most genuine trigger is the Fed, not the Middle East or Russia.”


So if bad news is good news, so to speak, then should everyone now be wary of any acceleration of the economy that hoovers up the remaining spare capacity and sees jobs, wages and consumer price growth pick up?

If rate rises by the Fed - or the Bank of England, European Central Bank or Bank or Japan - are going to be the trigger to end this five-year-old equity bull market, then presumably a build-up of sparky economic data will be necessary to surprise investors already braced for small, slow and gradual hikes.

“Markets just don’t die of old age, they usually get killed off by a shock,” said Kerry Craig, global markets strategist at JPMorgan Asset Management.

A monetary shock of that scale looks far fetched right now, with global inflation near its lowest across the Group of Seven richest countries in over 40 years. Craig at JPMAM, for example, reckons the slow growth, low inflation and decent earnings story can persist for much longer.

To be sure, geopolitics always has the potential to shock, but the power of that punch to the economy usually needs an added factor such as an oil price spike.

And despite the rampaging conflicts across the Middle East and eastern Europe this year, that’s just not happened. Crude markets are sufficiently well supplied to see oil prices fall to their lowest in over a year.

So what could juice up the economic numbers enough to force central banks to reconsider their assumed monetary timelines?

The one big shoe that’s not dropped in this recovery has been capital and wage spending by companies, who’ve hoarded cash instead for a variety of reasons related to their gloomy view of future demand or higher pension and healthcare commitments.

An added fillip to the ‘bad news is good news’ idea for equities has been that the absence of this confidence to invest in updating businesses or rewarding staff has meant firms have opted for share buybacks instead.

And so, long deemed the missing ingredient in the global recovery, a significant capital expenditure revival could well be the trigger for a stock market reversal.

The big risk for equity in this scenario is that a spur to growth from any corporate switch to capex spending, recruitment and higher wages away from share buybacks would not only lift bond yields and cut the equity risk premium, but it could also potentially squeeze margins and bottom lines.

“If you see wage growth come back, that could be one risk to markets,” said Stephen Cohen, chief investment strategist for BlackRock International Fixed Income and iShares EMEA.

Good news is bad news indeed.

Graphics by Vikram Subhedar. Editing by Susan Fenton

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