By Alberto Matellán, chief economist at MAPFRE Inversión
The dynamics of the financial markets can be reduced, simplifying greatly, to two main aspects.
- In the short-term, investment flows and liquidity are the kings. In a “classic” market, liquidity should be relatively constant, but in the real world, we could say that not only is this not the case, but in recent years, the liquidity provided by central banks has been critical.
- More in the long-term, the outlook for companies, and in particular, their earnings results, are the determining factors. Earnings can be understood universally as the difference between the return on capital invested (which in the long-term can be identified as nominal growth) and the cost of capital, i.e., interest rates.
In a period of uncertainty as we are currently in, and in the absence of clear references, it’s important to properly consider both of these factors.
Accuracy of growth and interest rates
Macroeconomic prospects have hardly changed in recent months. This may be why the markets have remained so stable, with the exception of occasional fluctuations. Investors expect new references in some key variables: inflation, growth or interest rates, although they are as yet unchanged.
Expected growth remains low, but positive, without much change in market consensus over the last two months. Economists continue to bitterly debate whether the economy will go into recession or not, but investors prefer to deal in hard facts. As such, and given the overall lack of consensus on the matter, asset prices aren’t linked to this variable.
Normally, changes in growth forecasts are anticipated thanks to the macroeconomic surprise index. It’s surprising to note that this has fluctuated significantly without the growth forecasts having really changed much. It’s true that results in Europe are certainly lower than those in the United States, where they have rebounded sharply, meaning concerns around growth are contained to Europe, where we can see indicators related to credit finance demand, construction activity and confidence sliding south.
Inflation is following a similar path. The latest publications haven’t provided much new information and the forecasts remain unchanged. Inflation remains uncomfortable for central banks, however, given that a reduction to the 2% target level would require a very sharp slowdown in growth that they aren’t willing to swallow right now. That’s why, little by little, the idea of sustained inflation of around 4% is gaining traction, which would imply a readjustment of interest rate expectations. This is especially applicable to the underlying rate, where high levels are one of the main drivers for this change in forecasts.
With regard to other variables, potential rate rises haven’t really been altered. However, it seems that the probability of a rate cut by the US Federal Reserve has soared, as we had anticipated. But changes are extremely subtle. Investors are reluctant to give much credence to central bank messaging, especially that emanating from the European Central Bank (ECB).
In short, there’s been little change so far in terms of nominal growth and interest rates, so investors are still waiting for some sign that will tilt the balance, which is why liquidity is a determining factor in the current scenario.
Liquidity is the key short-term variable
Liquidity can be studied from different angles, but its dynamics are mainly defined by the increase or decrease in stimuli implemented by monetary and fiscal authorities. There is a second factor that’s very important under normal conditions but which is not on investors’ radars so much these days and that is risk appetite. When this appetite is higher, the monetary multiplier of the market rises.
The current situation seems to be deteriorating in this regard. It’s true that we’ve seen some positive data in recent weeks, such as US bank deposits or the agreement on the debt ceiling. But the most important driver, namely central bank injections, tends to be negative, mainly due to the quantitative tightening that is being carried out, although on a reduced scale compared to a few months back. In short, while there is still a lot of liquidity in the market, it looks set to decrease in the near future.
In addition, the end of uncertainty on the debt ceiling isn’t as positive as it seems. In the coming weeks, we’ll see $500 billion (£390bn) flow directly to the markets. This may be positive in the long-term, in that it will contribute to ending this monetary tightening phase, but for now, the direct effect is a liquidity leak. Theoretically, this will affect the private sector, but liquidity will be directed first to the markets and, in particular, to the debentures market. It’s also negative for banks, because it will cause a fall in the value of their government bond portfolio, even if it’s an issue that hasn’t been given so much attention. This will put upward pressure on long-term interest rates.
Conclusion: an expectant attitude in the markets
The market is evolving while awaiting data to clarify the macroeconomic outlook and interest rates. The risk of recession is more important in Europe than in the United States, but in both cases, it seems less important than the market would appear to be contemplating. At the same time, inflation seems to be a more important risk than expected on the part of investors due to the difficulty being encountered in reducing it, although the volatility of same and the phase effect make it a focus of uncertainty.
This waiting game will continue to play out until central banks change their messaging. In the meantime, the market will focus on liquidity.
In the short term, the main debate is whether or not we are looking at an imminent recession. That said, attention should be paid to something that seems to be escaping the market. Defining a technical recession as negative GDP growth over two consecutive quarters can be misleading for investors. This in itself doesn’t affect the pricing of assets, the impact on which is more due to the variables included in the official US National Bureau of Economic Research (NBER) definition of recession, which is much more complex, considering as it does variables mainly related to income and employment.
The key feature of a recession is that the dynamic between these two elements inverts from a positive to a negative relationship. Basically, in a normal situation, an increase in employment means an increase in income, which translates into higher consumption and investment levels. In a recession, the opposite occurs. The key variable to consider when determining if an economy has entered into recession or not is a negative impact on employment. That’s why, as per the data published, we don’t foresee a recession in the United States or Europe.
Furthermore, given the absence of clear direction, recent investment flows toward US tech companies are part of a search for higher returns in the long term. It’s clear that the market is betting on AI-focused companies, which undoubtedly have great potential, although it is legitimate to ask if they would attract such a premium in a less liquid investment ecosystem. What is clear is that the search for the next batch of market winners is underway.
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