Market sentiment hit a renewed low in the second week of February 2016, matching the extreme bearishness in mid-January 2016. The levels recorded on the weekly Bullish Sentiment Index published by the American Association of Individual Investors (AAIIBULL index on Bloomberg), both in mid-January and mid-February 2016, are among the lowest handful of readings in a decade, as well as within the lowest dozen weekly readings since mid-1987 (see exhibit 1 below) when publication of this index first began.
Sentiment got to such bearishness based on fear factors including a hard landing in China, an ever declining oil price that would cause bankruptcies and the possibility that the US is headed for a near-term recession as well as concerns that policymakers are out of ammunition in a world where global growth and inflation are both faltering badly. In early 2016 markets came to believe that the world was in a crisis rivalling the many crises experienced in the past 25 years including the Asian debt crisis of 1997-98, the Internet crash of 2000, the terrorist events of 11 September 2001, the Lehman bankruptcy and Great Recession that ensued, the European debt crisis of 2010-12 and the US Treasury credit downgrade of 2011.
Exhibit 1: US investor sentiment bullish readings – as measured by the ‘bullish sentiment index’ published by the American Association of Individual Investors
Source: American Association of Individual Investors, 26 February 2016
Since that low point in sentiment, Chinese officials have been able to dispel the notion that a hard-landing in growth and a significant devaluation of the renminbi is quite likely in the near term. Oil prices have stabilised above USD 30 a barrel (and even risen by 20% off the lows). The talk of a US recession has faded somewhat as economic data have begun to surprise to the upside after more than a year of weaker-than-expected readings (see exhibit 2). The Atlanta Federal Reserve, which computes an ongoing estimate of current quarter GDP, now has a running estimate of 2% for Q1 2016 GDP after an actual dismal 1% in the fourth quarter of 2015.
Exhibit 2: After more then a year of weaker-than-expected readings, economic data in the US have begun, since late January 2016, to surprise on the upside – US Economic Surprise Index
Source: US Economic Surprise Index, 26 February 2016
On the inflation front, US inflation is also showing signs of picking up from low levels, as readings on consumer price inflation (CPI), producer price inflation (PPI), and the implicit price deflator for Personal Consumption Expenditures (PCE) have all surprised on the upside. This welcome increase in the rate of inflation in the US justifies the Federal Reserve’s (Fed) decision to take a first step to begin a normalisation of rates in December of 2015. It also reflects the fact that labor markets are better, and that consumers are more willing to spend with higher incomes and low energy prices. The US housing market continues to benefit from low mortgage rates that are unlikely to spike higher any time soon due to a cautious Fed.
Central banks have been perceived as running out of ammunition as interest rates in Europe have plunged to negative levels across a range of maturities up to 7 years, the Bank of Japan (BoJ) has moved the deposit rate to a small negative level, and ten year maturity Japanese government bond yields have also turned negative. Negative interest rates are correctly perceived by market participants as abnormal, and problematic, especially for the banking sector. Even the Fed acknowledged that they are studying the theoretical possibility of negative rates for future needs, though it is unlikely that such a tool would ever be utilised in the US. An important series of central bank meetings around the world is just ahead of us: with the ECB on 10 March, the BoJ on 15 March, followed by the Fed on 16 March. As a rule, it is not wise to wager that central banks will be unable to affect market sentiment for long, though the BoJ’s unexpected easing on 29/01/16 engendered a negative reaction. We would expect even better market sentiment readings after the upcoming set of central bank meetings and policy decisions.
In summary, we believe that markets are recalibrating expectations after having reached a low point in the first two months of 2016 due to two distinctly opaque factors: China and oil. Fears have now subsided on both factors, while US growth and inflation are finally improving, though the signals are tentative as usual. It is likely that US growth will again register in the 2 to 2.5% range for the balance of 2016 while US inflation moves gently toward target. The Fed will continue raising rates very gradually and strive not to upset markets. Though we should not expect vigorous growth globally, the US economy will eventually pull the rest of the world along. Based on such a benign forecast, we would expect that the US dollar will continue to rise, mostly against the eurozone where inflation remains much too low, and that emerging market assets—which have been decimated over the past few years–will eventually find some support on a selective basis. Most importantly, a US or even global recession is probably not a highly likely event in 2016.