With the stock market selling off near 30 points on the S&P 500 by the close Tuesday – the Russel 2000, a “Trump rally” staple, was down 2 ¾% on the day and now negative on the year – a European Equity Strategy report from Morgan Stanley makes four key weekly observations. Chief among them is a widening gap between hard data and “ soft data ” US economic data, one that points to trouble for the stock market. This comes as corporate stock buyback programs appear to be having more success in the EU than the US and bond flows are outpacing equities as a strong pace of Fed rate hikes lies ahead.
Soft Data
Differential between hard and Soft Data at among widest point of divergence in history
When Donald Trump’s surprise election created significant market volatility – stocks initially sold off significantly before recovering in the morning, then gaining significantly higher – such upside market volatility was unique in history.
The election ushered in a sense of confidence that was anecdotally noted – bringing out “animal spirits” where issues such as deregulation and tax reform for instance. There were also indicators regarding “soft” data such as sentiment that can be quantifiably benchmarked. The University of Michigan’s consumer confidence numbers are up along with CEO confidence figures and manufacturing firm confidence.
Such “soft” data measuring how people feel is juxtaposed to “hard” data, which wasn’t sending as confident a message.
Morgan Stanley’s European research team of Graham Secker, Matthew Garman, Krupa Patel and Lillian Huang note the divergence with hard data. Growth in residential investment has remained stagnant while traditional measures such as GDP growth, business investment and average wages have remained sluggish.
In fact, the differential between the “soft” and “hard” numbers was at its second widest point in 17 years of measuring data – February 2011 was the only other example of such a data divergence.
The gap between soft and hard data is historically a sign of stock market trouble ahead, the March 17 Morgan Stanley report noted.
Specifically, the analysts state:
When the gap between the ‘hard’ and ‘soft’ data has reached similarly elevated levels, it has usually been a negative signal for equities. The main occasion where this was not true was in 2009, where economic sentiment had started to improve rapidly ahead of a subsequent improvement in hard activity data. However, if this proves to be an occasion where hope is triumphing over reality, equities would appear vulnerable.
Stock buyback strategy has lost its power, but don’t fear the interest rate increases, even if they become aggressive
But it is not just the differential between hard and soft data that is among Morgan Stanley’s key weekly observations. Stock buyback programs – the practice of financial engineering where a corporation buys its own shares of stock, most often boosting the stock price – appears not to be working in the US to the same degree as it is in Europe.
The volume of European stock buyback programs is at a ten year low. But despite the lack of popularity of the corporate tactic, it is working to a higher degree. Those European corporations engaged in buybacks are doing significantly better than their regional counterparts who are not engaged in such stock price enhancing exercises. Noteworthy, however, is how the buyback practice in Europe is finding success when the strategy is apparently not widely used by corporations, but in the US, where the strategy is popular, buybacks are underperforming relative to their European counterparts.
The lack of power behind the buyback strategy in the US comes as asset flows into US bond funds are outpacing comparable flows into equities.
With interest rates rising – and talk of multiple Fed rate hikes making bond investors nervous, as the value of a bond declines when interest rates rise — US bond funds have actually seen fractionally stronger inflows than US equities, the report noted. “We illustrate though, that relative performance of equities vs bonds usually leads flows by ~6M, which would suggest an impending rotation, as the returns from equities vs bonds has reached a 3Y high.”
But don’t entirely fret those rate hikes. The fourth insight that Morgan Stanley noted was the impact of Fed rate hikes – even aggressive ones – not necessarily being a stock market negative.
A pace of 4-5 rate hikes in any 12M period is normal during a hiking cycle. While this pace of hikes may appear alarming, historically equities have usually performed fine during these periods, as rising EPS has trumped lower valuations. The price reaction from US bonds and equities to this week’s rate hike was the most bullish in 18 years, and the seventh best in history.
Don’t fear the rate hike, investors.
