What a difference a month makes. Last month, we were concerned about irrational pessimism in the markets and since then, we have seen a massive rally.
Such volatility is likely to be an ongoing feature this year. What fascinates us is that the discourse seems to be more sanguine, yet the correlations have not changed: equities have rallied in line with crude, perpetuating the idea that low oil prices are bad for world growth and hence for stocks.
Yet energy earnings have dropped from 11.5 per cent of total S&P earnings to 4.5 per cent. Energy also has fallen from 10 per cent of US non-residential fixed investments in equipment and structures to 5 per cent.
So why are equities still so tightly bound to oil prices? Perhaps because the basic equation has not changed in market participants’ minds: China’s slowdown equals lower commodity prices, reflecting lower global growth and hence lower overall corporate earnings. The fact that many industrial companies benefit from lower commodities, let alone the service sector, does not register in this analysis.
We have some sympathy for this thinking, however, as long as world growth does not rally meaningfully, because no hard data dispels the negative news loop.
Nonetheless, there is a flaw in that analysis: why is the jobs market so buoyant in the US, why is consumer spending still growing at a post-recession high and why have US inflation break-evens rallied sharply?
Someone, somewhere, expects that US growth will not fail. The conundrum is that there are many data points showing a struggling manufacturing sector in most regions of the world.
This slowdown, though, does not cause contagion to the rest of the economy. Not in the US, Europe or Japan, where services are leading economic growth.
The trouble is that industrial stocks are over-represented in equity markets, whereas services are under-represented. The Ubers of the world may attract customers but they are not publicly quoted, whereas steel companies are part of all the indexes.
This confusion is leading many investors to stay on the sidelines rather than face complicated investment choices. Yet there are some potential changes in the world economy that could help investors to reposition themselves.
The long streak of poor productivity in the US may be about to end, with R&D spending recovering in the past two years; there is pent-up demand in capital expenditures and wage growth hitting corporate margins that could help to release it.
The consumer may return to more traditional saving and spending patterns after the recent surge in savings; all it would take would be a rise in mortgage rates to bring some fence-sitters into the housing market.
In China, the monetary stimulus accumulated over the past eight months may boost the economy.
In Japan, the summer upper house elections may prompt the Shinzo Abe government to favour fiscal policy over monetary policy and help spending by further postponing next year’s sales tax hike and driving a labour market reform through the tax system.
Last, but not least, in the euro zone banks have been given a lifeline through additional targeted longer-term refinancing operations, helping bank credit and hence the economy.
On the downside, despite their bounce, oil prices could take longer to stabilise than expected and drag markets down again. The Federal Reserve could dither on its rates policy and confuse investors yet again. First quarter earnings may still lag.
Altogether, though, we see risks as more evenly balanced in the short term with some positive potential thereafter. Markets are so stuck in a valuation debate that focuses on US$120 in S&P earnings with a 16 times multiple that they may miss any additional growth potential along the way.
It is now clear that the volatility and disappointment we have seen since last summer was mainly caused by a downwards reappraisal of world growth prospects. This mindset is highly vulnerable to upside surprises.
Michel Perera is the chief investment strategist for Emea at JP Morgan Private Bank