Why do risky assets like stocks sometimes respond positively to bad economic news?
It feels intuitively wrong. After all, any indications that the global economy is slowing suggests that the pace of earnings growth will ultimately start slowing too. Lower equity earnings growth suggests lower valuations because the price of an equity is simply the present value of all its future earnings.
The key to the “bad is good” puzzle lies in how present values are determined. It’s not just about earnings but it’s also about the rate at which those earnings are discounted back to the present. The higher the discount (or risk free) rate the lower the present value of the earnings stream. It’s entirely possible therefor to have lower earnings but a higher valuation, if the discount (or risk free) rate is sufficiently reduced.
So how have global markets been reacting to the growth and interest rate dynamic of late?
The months of May and June proved instructive. The decelerating global growth outlook together with ongoing trade tensions more than offset declining bond yields in May with the result that equity markets performed poorly. At this point the “bad is bad” thesis prevailed. However negative market movements and lower bond yields resulted in improving earnings yields (earnings per share divided by the share price) versus bond yields over the month. The earnings yield above bond yield metric (a form of what we call the equity risk premium) expanded from below 2% to above 2.5% for the benchmark S&P 500 index. A better valuation at the start of June together with an ongoing decline in bond yields (as a result of more central bank dovishness and a benign inflation outlook) and reduced trade tensions saw markets recover strongly in June.
So was this a case of “bad is good” again?
In some respects the answer is yes in that weak economic indicators prompted more dovish remarks from Central Banks. This needs to be qualified however. The “bad” was not quite that bad. Indeed while indicators were soft there were signs that the pace of global growth deceleration could start to ease. In other words the growth outlook may become somewhat” less bad”. This combination certainly proved to be quite equity supportive over June.
So where are we right now in our assessment of the investment merits of the various asset classes?
Global equities are by no means cheap in absolute terms given strong performance year to date and a challenging earnings growth outlook. Having said that earnings yields have improved relative to bond yields. While many market commentators suggest that plunging bond yields are indicative of increasing recession risk a global recession is not in our forecast horizon.
On this basis we certainly prefer global equities relative to developed market bonds at this time.