Stocktake: Is a market ‘melt-up’ on the cards?

US stocks are on the verge of all-time highs after gaining almost 25 per cent since December’s low, but there’s a bigger chance of a market melt-up than a meltdown.

That's according to Larry Fink of BlackRock, the world's largest money manager. Fink's point is that many investors have remained sceptical of the rally, with "huge pools of money" still sitting on the sidelines. Investors had assumed this would be a period of rising rates. Wrong-footed by the Federal Reserve's dovish U-turn, there was "huge underinvestment, and people had to rush into fixed income", he said last week. In contrast there's been no such rush into equity markets.

Fink may be overstating things. Funds were seriously underinvested at December's market bottom, but things have changed recently. For example, the Merrill Lynch fund manager survey for March showed equity allocations to be way below historical norms, although the latest survey (more of which anon) shows exposure has normalised after a big jump in April. Similarly, Credit Suisse notes hedge funds' exposure to US stocks has bounced following multi-year lows, while the main exchange-traded fund (ETF) tracking the S&P 500 recently enjoyed its biggest weekly inflow of the year.

Nevertheless, Fink is right to note there’s no euphoria out there. Markets may not melt up, but indices can continue to grind higher.

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Risk appetite is normal, not excessive

Headlines such as "Fund managers shrug off recession fears and pile into shares" make it sound like investors are in recklessly bullish mood, but the data in the latest Bank of America Merrill Lynch (BAML) monthly fund manager survey tells a different story.

Yes, almost all – 86 per cent – say the recent inversion of the US treasury yield curve does not signal a 2019 recession. And yes, the percentage of investors overweighting stocks has seen its biggest jump in more than two years. However, while an inverted yield curve is seen as a reliable recession indicator, the norm is for recessions to begin up to two years later. In other words the reason fund managers don’t envisage a 2019 recession isn’t because they’re complacent; it’s because a near-term recession remains extremely unlikely. As for the jump in equity allocations, March represented “peak bearishness”, to use Merrill’s phrase. April’s rebound simply means risk appetite has returned to normal levels; there’s no evidence of excess. Cash balances, too, are unchanged this month and remain higher than normal – again, no hint of euphoria.

Excessively bearish sentiment has been a tailwind for stocks in recent months. Sentiment is now more neutral and is no longer a tailwind, but nor is it a headwind – despite what the racy headlines might suggest.

Investors still sceptical towards Europe

European stocks hit eight-month highs last week, but sentiment remains cautious. Short bets against European stocks remain the most crowded trade in the world today, according to BAML's survey. Allocations have jumped over the last month but only to neutral levels – again, there's not a whiff of excitement out there. Indeed, a Bloomberg poll of strategists shows they expect the Stoxx Europe 600 Index to fall 9 per cent in 2019 from current levels.

Disappointing economic data is no doubt having an impact on sentiment. Euro zone manufacturing data was unexpectedly weak last week, while the German government announced that it expected economic growth in 2019 to be the lowest in six years. Despite lacklustre data, European stocks have raced ahead this year, gaining 15 per cent.

Strategists’ instinctive reaction may be to see equity gains as unsustainable, but the correlation between stock returns and economic growth is tenuous, at best. The sentiment picture suggests many investors are steering clear of Europe, so any upside corporate surprises could see short traders cover bets and bring cautious investors in from the sidelines, driving further gains. Right now it seems European markets are climbing the proverbial wall of worry.

Recession next year looks likely, says CFOs

Fund managers may not be worried about a US recession occurring in 2019, but things might get hairy in 2020, according to Duke University’s latest quarterly global survey of more than 1,500 chief financial officers.

Two-thirds of CFOs expect the US economy to be in recession by the third quarter of 2020, the survey found, while almost all – 84 per cent – believe a recession will have begun by early 2021. These are high numbers, with survey director John Graham noting it’s unusual for so many CFOs to envisage a recession within 16 months. CFOs are less concerned about 2019, with fewer worried about the possibility of a near-term recession compared with the previous survey; then, almost half thought the US would be in recession by the end of 2019, an inflated reading that was surely influenced by December’s sudden market plunge.

Nevertheless, it’s clear CFOs have grown increasingly concerned; just 24 per cent have grown more optimistic about the US economy, compared with 53 per cent a year ago. There is, says Harvey, “consensus that a downturn is approaching”.