This year has been peppered with nasty surprises for investors. But there are several potential triggers for a broader rally in equities in the closing weeks of 2019.
Topping the wishlist of institutional investors by a considerable margin is a trade agreement between the US and China, according to the latest monthly survey compiled by Bank of America Merrill Lynch, which gathered the views of 175 global institutions managing US$507 billion ($794.5b) of assets.
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Further down the list, investors would also welcome a burst of greater spending by Germany and China, along with a further half a percentage point of "insurance easing" by the US Federal Reserve. A smooth Brexit transition between the UK and EU is also seen as fuel to drive equities higher in the next six months.
Should a case of deal euphoria erupt, there is considerable scope for a strong market reaction. It would also run against much of the defensive positioning that dominates portfolios at the moment, generating potentially big shifts in asset prices.
Outcomes could include a kick higher in long maturity bond yields, and a weaker US dollar, particularly against emerging market currencies. Equities would see stronger leadership from cyclicals, or companies exposed to the economy, which means share markets in emerging economies and Europe would rally more than Wall Street. Higher long-dated bond yields would also favour financials, rather than other cyclicals such as industrial companies.
Of late, we have seen hints of such reactions whenever upbeat headlines over trade, Brexit and German fiscal stimulus have cropped up, so investors are on notice that bigger shifts loiter on the horizon.
Notably, Eurozone and UK domestic equities have outperformed other big markets in the past month, while the recession signal from the US bond market has faded. The 10-year Treasury yield has moved back above that of three-month bills after this relationship turned negative in late May.
One question is whether a burst of optimism would generate just a short-term portfolio rotation, or whether the global economy is poised for an upswing that stretches out an already lengthy economic cycle and dodges recessionary forecasts.
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Precedents for a more upbeat outcome include the rebound during the late 1990s, the rise in activity after the eurozone crisis and the bounce back from the growth scare of 2015-16.
It is striking, given the number of factors that could go right, just how many investment managers are nonetheless sticking to defensive portfolios. Many seek comfort in having scope to liquidate their holdings in a relatively short span, say around 20 days.
This betrays a lack of conviction about the economic and financial outlook, hardly a surprising conclusion given that memories of 2008 run very deep. It also reflects fears that a long-term schism is developing between the US and China.
As for a trade deal, the views of investors fall into several main camps. Courtesy of BAML's survey this week, one group (43 per cent) thinks any flickers of optimism, such as those generated by the recent meeting in Washington between trade teams, are destined to fizzle out. On this reading, the reality framing the next decade is that a combative and cold war rivalry between the two powers constitutes a "new normal".
A rival view (pegged at 36 per cent by the BAML survey), and one that helps explain some of the resilience seen in equities for much of this year, is that a deal will probably be struck before the macro climate turns wintry. This entails a series of phases towards a compact before next year's US elections.
The idea that macro deals will arrive, ranging from trade to German fiscal stimulus and Brexit, reflects a sense among investors that officials will strive to defer the next recession. Whether relief arrives in time to avert a harder landing only heightens the current anxiety among asset managers about their portfolio choices.
Kristina Hooper at Invesco sums up the prevailing mood over trade relations: "The fog of trade uncertainty has thinned, but it is far from having lifted. Investors should remain diversified for the rest of the year and heading into 2020 — a year expected to be fraught with geopolitical and trade volatility."
That may be a wise course as there is another unwelcome side to deal euphoria, as it will arrive when there are already signs of rich asset valuations. This week the IMF warned that "equity markets appear to be overvalued in the United States and Japan" and noted credit risk premiums "also seem to be too compressed relative to fundamentals".
The current environment, as recently noted by Chris Iggo at AXA Investment Management, is challenging for all investors and not just from trying to ascertain the best "combination of assets and risk profiles".
There might yet be a sting in this tale. As Iggo puts it: "It would be ironic if the market reaction to clearing of policy and geopolitical uncertainties was higher rates and a more typical financial-squeeze led recession."
Written by: Michael Mackenzie
© Financial Times