Everything Is Getting Worse, so Buy Stocks, Obviously

Fund managers are losing confidence in prospects for the economy and inflation, yet still see equities outperforming. There is no alternative. Photographer: Bill Pugliano/Getty Images There’s Still No Alternative

Gently, but steadily, economic expectations are coming down. It may be an overreaction to the wave of Covid-19 caused by the delta variant, or it may be a response to incoming data, or it could reflect dampening hopes for an expansive new fiscal policy in the U.S. as the standing of President Biden also dampens. But for whatever reason, hopes for a big new “reflation” or even a post-Covid “reopening” have dwindled.

One thing remains unchanged by this, however. The great majority of investors are still convinced that there is no alternative to stocks. Even with drabber economic growth in prospect, which should help fixed-income more than equities, the overwhelming consensus still calls for stocks to outperform bonds.

For some great data to substantiate this, look at the latest fund manager survey carried out by David Bowers of Absolute Strategy Research Ltd. in London. It involves asking a regular panel of investors to put a probability on certain market and economic outcomes, rather than asking about their positioning. The latest survey, completed just before last week’s Federal Open Market Committee meeting, received responses from 216 managers, overseeing $4.3 trillion of assets, and found a big majority (72%) still confident that stocks will beat bonds over the next 12 months: This is true even though the belief that inflation will continue to increase has taken a dive since the second quarter. The majority now thinks that the core PCE deflator, the Fed’s favorite indicator, won’t be higher in 12 months from now: Even though most managers are on Team Transitory, there are still comfortable majorities who expect higher commodity prices, and who expect Treasury inflation-protected securities, or TIPS, to beat regular bonds. So this is a strange combination. If we look at how the probabilities of all the scenarios offered to the fund managers have moved since the second quarter, the clearest trend is a loss of belief in higher inflation, anyway. There is also less confidence in higher corporate earnings, and in value to beat growth, and cyclical stocks to beat defensives. There is greater belief that we could be facing a global recession. Attached to these, there is greater belief in the dollar to the strengthen and U.S. equities to beat non-U.S. equities, as might be expected during an economic slowdown: Intriguingly, all of these positions co-exist with a belief that the Fed will grow more hawkish, and start to move the fed funds rate higher within the next 12 months. Not long ago, that was perceived as very unlikely. And again, to be clear, this survey was completed before the latest FOMC, in which Jerome Powell suggested that the plan was to finish tapering asset purchases next June, with interest rate rises to follow: In line with this, there is an expectation of higher 10-year yields in a year from now. That makes sense if the Fed is raising rates, but of course higher rates would seem to make less sense if inflation isn’t rising and the possibility of a recession is looming: Note that investors have been almost perpetually braced for higher 10-year yields, and yet they have been almost perpetually wrong. (I feel their pain.) This chart shows subsequent 12-month percentage moves in the 10-year yield since 2018. Until the pandemic shook everything up, expectations of increases went regularly unfulfilled: Expectations Unrealized

Investors braced for higher 10-year yields in 2018 and 2019; but they fell Putting the various elements together, this suggests that investors are braced for a hawkish error by the Fed; inflation isn’t going to be more than transitory, but rates and yields are heading up and the economy is slowing down. Despite this, there is continued confidence that high-yield bonds will beat investment-grade (which in turn will beat Treasury bonds): Putting everything through the Absolute Strategy Research algorithm, we discover that belief in inflation is still the critical dividing line between bulls and bears. Those who think that inflation is more than transitory are far more likely to think that a 20% drawdown for the S&P 500 lies ahead, while those on Team Transitory are much more confident about stocks. Optimism for the economy as a whole is continuing to fall: These findings are in line with other results. The Citigroup Inc. Economic Surprise indexes for the U.S., the euro zone and China show that […]

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