Is Europe Well Positioned To Sustain Its Equity Leadership Position?

Global equities broke out last week, ending the two month consolidation phase. A strong earnings season, upbeat guidance and reduced geopolitical uncertainty have spearheaded the breakout and financial conditions have eased substantially falling to multi-year lows.

Last September we postulated that the global Equity Risk Premium (ERP) would continue to narrow on the back of easy global monetary policy and a recovering global economy. While the Fed has hiked interest rates twice since then, global monetary conditions remain loose and we doubt they are about to abruptly tighten. Leading indicators signal that the global economy is also on track to continue expanding at a healthy clip, sustaining a goldilocks equity market scenario.

Historically, the ERP and global growth have been inversely correlated. The current message is to expect a further narrowing of the global ERP. Importantly, the ERP has consistently moved higher, rising about 300bps per decade on average for the past 20 years. Were the ERP to break 4% (and still remain ~200bps above last decade’s mean) from 4.84% currently, all other things equal, then the MSCI All-Country World Index (ACWI) would rise by 15%.

Nevertheless, regional equity market returns will not be uniform. Drilling beneath the surface of recent G3 performance is instructive. As a reminder last September we highlighted that “the laggards (Eurozone and Japan) will have to do the heavy lifting in order to propel the MSCI ACWI into uncharted territory”.

Indeed the Eurozone and Japan have been leading the charge especially since the Trump election. While the U.S. has hit a small speed bump recently, the Eurozone and Japan are firing on all cylinders according to sharply divergent Economic Surprise Indexes (see Chart). The implication is that Europe and Japan are well positioned to sustain their equity leadership position in the coming months.

True, the bond market has not yet confirmed the equity market’s euphoria, but leading indicators…

For additional details, please see the May 5th Report titled “Buy The Breakout”, available at gss.bcaresearch.com.

High Speculation In U.S. Equities

While the BCA’s cyclical stance on U.S. equities remains positive, it is critical to be aware of the high degree of speculation.

BCA’s Equity Speculation Index (ESI) signals that the U.S. stock market’s advance is at a very high risk stage. That said, the ESI can stay in elevated territory for a prolonged period before a market decline unfolds, as it occurred in 2014/2015. The eventual weakness in equities in early 2016 turned out to be a mid-cycle correction. However, the elevated ESI readings in 2000 and 2007 flagged the deep bear markets.

Without a recession on the immediate horizon, given the still upward sloping yield curve, it is premature to expect a repeat of 2000 and 2007. However, a market correction cannot be ruled out. While BCA’s 9-12 month outlook for U.S. equities is positive, investors should maintain some non-cyclical exposure in the event of a short-term market pullback.