Why are investors still buying the dip?

Sometimes it's what we cannot see that is most important.

Now that global equity indices have staged a strong comeback rally throughout March, a lot of head scratching and tea leaf reading is occurring. How to explain this explosive turn in sentiment when the war in the Ukraine is still raging, bond markets are flashing warning signals and forecasts for inflation are on the rise, still, while forecasts for economic growth (and thus corporate profits) are declining?

Amidst all the finger pointing at technical trading, short covering, the US options market, and a continuation of buy-the-dip strategies -that all made their contribution, no doubt- one most interesting piece of research has been released by the global strategy team at Citi led by strategist Robert Buckland.

On the team's analysis, global equities continue to be supported by the fact that 'real' bond yields ('real' meaning corrected for inflation) are still negative, irrespective of the rapid rise at face value in 2022, and Citi's house view remains that real yields will likely remain in the negative throughout 2022.

What this means, explains the team at Citi, is that every time investors move into cash, they rather quickly draw the conclusion there is no viable alternative other than equities to put that cash back to work. Commodities can only absorb so much, and they remain highly volatile. Bonds are still selling, carry a negative 'real' return and the curve is flat as a pancake, if not negative (i.e. inverted with less yield farther out).

The past years have seen so-called alternative assets gain in popularity but as Citi rightfully points out, alternative assets are illiquid and current pricing suggests they are expensive. Inflation protected bonds, or TIPS in the US, still guarantee investors a negative real return.

So where does one put money to work once the cash on the sideline starts feeling impatient?

In a negative real yield environment, Citi argues investors come to realise equities are, in essence, a real asset, just like commodities and real estate. Hence the logical reflex is to continue to buy-the-dip, because There Is No Alternative (TINA).

How do equities perform in periods of negative real yields?

Historical data-analysis seems to support Citi's thesis, with the team identifying five previous periods when real yields were negative, and all but one witnessed equities posting a positive return.

• 1971-1972 - S&P500 price return was 11%
• 1975-1978 - 17% price return
• 1982-1983 - 38% price return
• 2011-2013 - 35% price return

Thus far in 2020-2022 the S&P500 price return has climbed to 40%. Note no returns from dividends were included in those calculations.

The one exception is the period 2007-2008 when real returns sank into negative territory because of a global recession and deeply entrenched financial crisis with the return from equities sans-dividend falling to -37%.

Given the above analysis, investors might be inclined to think buy-the-dip remains the most solid, superior risk-adjusted strategy when it comes to equity markets, as long as no recession or financial crisis awaits on the horizon, but the team at Citi offers an alternative angle.

Maybe buy-the-dip stops working when real bond yields move into the positive. The implication here is that when this happens, investors will again start treating government bonds as a viable destination for parking their cash, even if it's only for a defined time.

On Citi's in-house projections, this won't happen until next year, in 2023.

Incidentally, quant analysts at JP Morgan make the point that investors should only read bond market yield inversion as a signal for economic recession if this inversion shows itself in the 'real' yield. This is currently not the case, and not anticipated to occur anytime soon either.

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Citi might well be onto something. Maybe the lack of viable options available outside of equities is acting like a natural protection to the downside, but share prices can still become too expensive, of course.

A recent market update by strategists at Morgan Stanley argues the March rally has pushed up indices too far. With all the risks that are lurking on the horizon, not the least the chances of a policy-error as the Fed is looking to accelerate its tightening over the meetings ahead, common sense would suggest equities should price in some of that risk, but so far bullish optimism rules.

To illustrate their case, Morgan Stanley strategists revert back to the principle of the Equity Risk Premium (ERP); simply put, this is the premium equities price-in vis a vis government bonds to take into account the bigger risks that reside with equities.

Following the sharp March rebound, the ERP for US equities has fallen to its lowest point post-GFC, which, in the strategists' view, doesn't make much sense "given the heightened risk to earnings growth from rising risk of recession next year, cost pressures, payback in demand, and a war that has structurally increased the price of food and energy--i.e., a tax on the consumer."

Strategist Mike Wilson & Co also observe how profit forecasts in the US are shifting further out, with short-term estimates falling, and once again make the point this should be another reason as to why the ERP should be rising, not falling. Note that a higher ERP implies equities should be cheaper than they are.

Morgan Stanley has put its modeling to work, incorporating higher inflation and bond yields and a slower trend in corporate profits, and the outcome is that if today's US market had been following the script from the past, indices should be close to -20% lower.

The big unknown remains, of course, how aggressive exactly will Fed tightening turn out to be? And will it end with economic recession?

Judging from the big gap between today's indices and what the modeling suggests, Morgan Stanley suspects investors doubt whether priced-in forecasts by bond markets are accurate. In other words: share markets are counting on the fact the Federal Reserve won't go as fast and as hard as currently suggested by bonds, and thus the chances of a recession are a lot lower too.

The obvious observation to make here is that economists are still lifting their expectations for the pace of Fed tightening this year, with the likes of Citi now forecasting 50bp hikes three, possibly four times in succession. Others are suggesting the Fed might might well hike by 75bp at its next meeting.

Needless to say, such moves are not yet priced-in, so there still is room for further negative surprises from the US central bank. The obvious question to ask is how the US economy will cope under accelerated tightening when inflation from food and energy already acts as an extra tax on most companies and households?

Which is exactly why Mike Wilson & Co are scratching their heads. Sure, we don't know the answers as yet, but should we not price-in some of the uncertainty until we do?

Damien Boey, chief investment strategist at Barrenjoey would concur with the above in that he too thinks most assets have not yet appropriately priced in the coming Fed funds rate trajectory, except, maybe, the US bond market. But Boey is drawing a correlation with a strengthening US dollar in response which should have negative consequences for Emerging Markets, as well as for commodities.

Meanwhile, have no doubt, the gap between those experts who foresee a much more malignant inflation cycle and those who believe the Fed will soon find out it cannot embark on an accelerated tightening cycle without pushing the US economy into recession remains as wide as ever.

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On Citi's data, revisions to global corporate earnings forecasts are trending deeply into negative territory this year. This should not be a surprise. We all know that higher prices for everything, from agricultural produce to energy, to timber, steel, transport and labour, ultimately translates into margin pressure for corporate consumers and into less spending capabilities for households.

No surprise, Europe and Emerging Markets are the most obvious victims, as are consumer-oriented sectors.

In Australia, however, forecasts are rising and this too should not surprise given the heavy index weight of the Materials sector. Iron ore is the biggest index component locally with BHP Group ((BHP)) now representing 11%-plus of the ASX200, but recent sector updates have equally lifted forecasts for producers of lithium, aluminium, oil and natural gas, copper, nickel and other base materials.

If anyone were still in doubt, commodities have found their sweet spot in 2022 and as long as supply remains restrained, there seems little on the horizon to end the party - for now. The added observation is that were commodity prices to at least hold onto current pricing levels, the potential for further upside in profits and cash flows for the sector remains significant.

A reminder: what is a great environment for producers, is not so great for consumers. Earnings forecasts might be rising in Australia in aggregate, but this masks the fact that estimates are falling for the likes of United Malt Group ((UMG)), Lendlease ((LLC)), Boral ((BLD)), Seven Group Holdings ((SVW)), and others.

Unsurprisingly, a recent share market strategy update by Macquarie suggested investors should "position as if it’s a commodity boom".

Underneath the surface, however, the market is polarising yet again. Citi analysts observe how commodity stocks have continued their rally in the US, but the more traditional cyclicals have failed to keep pace, unlike the pattern witnessed last year. when both appeared connected at the hip.

Citi analysts believe the answer lays within the price of oil. When the price is below US$70/bbl, any sign of inflation is seen as positive, but once the price surges above US$70/bbl and beyond, the market sees 'bad inflation' and the equities rally narrows to producers of commodities only.

On the ASX, an argument can be made investors are expressing their concerns and doubts through specific sectors and individual stocks. Shares in Wesfarmers ((WES)), for example, are trading well off from the peak of $66 from August last year, as well as well-below the $60 in early January.

Is this the doubt about consumer spending and/or further strength in the local housing market that is showing up?

One look at the share prices of Adairs ((ADH)), Temple & Webster ((TPW)) and Nick Scali ((NCK)) suggests the answer is affirmative.

In the US, the housing market seems to be rolling over. Now look at the share prices of Reece ((REH)), James Hardie ((JHX)), and Reliance Worldwide ((RWC)). Irrespective of these specific ASX exposures, investors might want to put the US housing market on their radar generally since analysts at Barrenjoey pointed out US housing demand is the single-best leading indicator of business sentiment.

Arguably, the market has selectively picked and chosen which risks should be priced in, and which ones not so much (at least not at this stage).

In a share market that is as polarised as it has been over the past seven years or so, maybe the real questions revolve around what segments are due for the next fall, and where is value starting to appear?

Within this context I did note JP Morgan analysts highlighting REITs are more sensitive to movements in 'real' bond yields, which probably explains why other brokers have been receiving questions from their clients about why REIT share prices on the ASX are holding up better-than-expected?

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