The equity rally over the past 18 months has been driven by multiple expansion. As Morgan Stanley's Gerard Minack notes, equity markets have been highly correlated with macro surprises – whether economic data have been exceeding, or falling short of, consensus forecasts – through this expansion. However, we note that the potential for a market setback is extreme; as the gap between what seems increasingly needed to sustain the rally – better growth and earnings news – versus the prospect of weaker US growth is as wide as it has been in five years. The macro news flow is now disappointing in the major developed economies. Moreover, there’s been a pseudo-seasonal pattern to the ebb and flow of surprises, with weakness typical in the middle quarters of the year. The very recent weakness in the US is more troubling though as it is set against the backdrop of already-sluggish global growth, which is most pronounced in the developed markets; and reflecting the sag in global growth (and earnings), global equities have already stalled outside the US. The out-performance of equities versus bonds over the past year is consistent with solid macro improvement and as the chart below indicates, that hope is fading fast.
Global equity valuations (MSCI World 1Y Forward P/E) have been highly correlated with G10 Macro Surprises. What should be very clear is the fact that Macro turns lead equity valuation adjustments (red arrows then blue arrows). What is more disconcerting is the current disconnect is very reminiscent of the levels and divergence that occurred in 2008...
And to confirm this 'hope' priced in - the relative performance of equity over bonds (orange line) already prices in a return to pre-new-normal levels of economic activity globally (judged by Global PMIs). However, those Global PMIs are not playing along...
It seems to us that between US (and Japan) dramatic outperformance of their G10 peers...
...and the disconnects between macro- and micro-valuations that BTFD in US equities now is hardly the 'cheap' shiniest 'turd' trade every asset-gathering talking-head suggests it is.
Charts: Bloomberg and Morgan Stanley