In the depths of market pessimism in the middle of last year Aaron wrote about how investors seemed to have given up any hope of interest rates ever increasing. That now seems a long time ago, at least if you consider market commentary.
It certainly seems that in developed economies, increasing inflation and even growth are at least being considered as possibilities in ways that they weren’t before. This is even the case in the UK and Europe, where equity markets have kept pace with the US.
The moves have been greeted with much scepticism, particularly by those who believe that Donald Trump’s election victory has been the only cause. This scepticism is particularly prevalent in Europe, where commentary has also stressed political risks in France and Italy and ongoing threats to the banking sector. Even Greece’s renewed bailout struggles, which once seemed like the only issue that mattered, have so far had little knock on effect to the rest of the continent.
Against this background it is hard to not to be concerned about the broad-based nature of equity strength.
In fixed income, there are signs of political stress in Credit Default Swaps and short dated government bonds. However, in contrast to the worst phases of the Eurozone crisis, markets appear to have been relatively discerning in the latest phase. Having initially focused attention on Portugal, more recent concerns have centred on Italy and France. The fears of total systemic collapse that characterised earlier years are not in evidence here.
Moreover, shifts at the long end of the curve have been more correlated, suggesting that Europe-wide growth and inflation considerations (as well as the impact of US rate expectations) have played a greater role than political fears.
It seems therefore that the strength of European data rather than Trump-based optimism or political fears have been the significant driver of price action. We can see this strength of recent data releases relative to expectations:
Even notoriously overoptimistic equity analysts are having to revise up their forecasts for next year’s earnings, a relatively rare phenomenon.
Ironically, these surprises are not in themselves surprising when we consider how depressed expectations had got by the middle of last year. Figure 7 below shows a survey of economists from over 20 major banks and economic advisory firms on what they expected Eurozone growth to be in 2017.
At the start of 2016 the majority of forecasters (around 50% as illustrated by the purple bar) thought growth would be between 1.7% and 1.9%. By July, only 4% had the same view, while around 60% believed that growth would be below 1.4% (the orange bars).
We should not be surprised that forecasters get things wrong, and moves in the oil price will have undoubtedly played a role in these estimates, as both Steve and Alex discussed last year. However such large swings reflect the extreme change in prevailing market sentiment last year.
What is interesting is that, despite the positive data illustrated by the surprise indicator above and the ongoing oil price recovery, growth expectations still appear pessimistic relative to the start of 2016 (interestingly no forecasters still hold the belief of 1.7% to 1.9% growth that the majority agreed with a year ago).
How we choose to interpret this information will likely depend on our own pre-existing views. Are markets getting carried away with themselves and ignoring both political risks and the pessimism of economists? Or have they simply partially unwound the deep pessimism that characterised the middle of 2016?
We would tend toward the latter; ultimately pessimism in Europe still seems pervasive despite a background of improving data. Such pessimism often suggests that there is some margin of safety for disappointment, and scope for a strong response to even modest positive surprises.
No-one knows how political risks will play out and very negative scenarios associated with single members leaving the European Union or the collapse of the union itself can easily be imagined. However, it is the very ease with which we can imagine these scenarios that suggests we are being compensated for them.