As stock and bond markets hit the half-way point in yet another year of bank stress, euro crisis, and disappointing global growth, early-year optimism has dissipated just as it did last year and the year before that.
But this year the gloom is already pervasive. Europe’s inability to draw a line under the eurozone’s debt crisis has been the chief frustration.
Global growth and earnings forecasts have been slashed again; euro breakup scenarios are now commonplace in investment thinking, if not positioning; hard-landing fears for the giant emerging economies of China and India are rife and nerves abound about the impact of built-in US budget tightening next year. Few could accuse strategists and fund managers of being over-optimistic.
But is the relentless pessimism already reflected in markets and are investor positions overly skewed to now negative real returns of cash and top-rated government debt?
“Bear in mind that tail risk is a two-way concept and we focus only on the negative at our peril,” said JP Morgan Asset Management strategist David Shairp, flagging an increase in equity exposure relative to bonds in JPMAM’s multi-asset funds and a shift to overweight European equity from underweight.
The twists and turns of the euro crisis and fiscal debate surrounding the US presidential election may be difficult to second guess. But, assuming worst-case scenarios are avoided, Shairp said there are other potential positives on the horizon.
One was declining, but still positive inflation rates worldwide as a commodity price retreat and a 20% year-on-year drop in crude oil prices feeds in. Assuming this disinflation allows further monetary easing by central banks while putting more spending power in consumer pockets, the outcome could prove surprising for the market.
“At a time when investors are nervous and running low levels of risk exposure to the asset class, any positive catalysts could prompt a shift back into equities,” Shairp said.
So how skewed is market positioning? Equity prices tell a story of stasis. When you strip away the euphoric leaps and gut-wrenching lurches, the MSCI all-country index of global stocks is back where it started in 2012. And that’s also where it started in 2010.
The fear factor and tail-risk hedging, however, is more obvious in bonds. At paltry, sub-inflation rates of between 1.5% and 1.7%, US, German and British 10-year government borrowing costs have fallen yet further this year and have now more than halved since early 2010.
Cash positions in global investment portfolios have surged again to more than 7% and are already back to levels not seen since the aftermath of the Lehman Brothers collapse, according to a Reuters poll of asset managers in May.
And the retreat from stocks has been steep, with aggregate holdings of equity in global portfolios falling below 50% in May to lows not seen since the post-Lehman recession.
But the bit that gets many fund managers is what this does to relative valuations, particularly in Europe as the euro crisis drives outside investors away and depresses the regional economic outlook. The implied future returns on equities over top-rated government bonds, the so-called equity risk premium, remains way above historical averages.