How Long Can This Rally Last?

The question we hear most from clients today is: How long can this rally last?

Over the near term, given the sharp rally over the year-to-date, investors should recognize that valuations are not as attractive as two months ago, and that a pullback is a possible.

As the bullish market momentum extends into its ninth consecutive week of gains, global equity markets (MSCI World Index) have by now clocked gains cumulating to an impressive 16%.

This post-Christmas rally has been mainly driven by 1) the Fed’s dovish policy about-turn and 2) positive sound-bites from both the US and China regarding trade.

The Fed’s communication of a pause in rate hikes and the likely scaling back of their balance sheet reduction moved interest rates (both nominal and real) down. Financial conditions also eased from the extremely tight levels saw in late December.

Together with the sharp decline in volatility, which reduced risk premiums, these factors acted in combination in driving capital towards risk assets.

As increasingly positive trade headlines from both the White House and the Chinese emerged over the year to date, the market also began to price in the scenario of no Sino-US tariff escalations at the end of the trade truce on 1 Mar 2019.

The delay in tariffs increases was confirmed by President Trump this morning, though it is still unclear if we will see protracted trade negotiations (with possibly an extended deadline) or a comprehensive trade resolution ahead.

Barring a trade resolution – which would be an upside surprise for the market - we are generally cautious that a fair bit of optimism on trade is by now priced into the market.

Chinese A-shares have outperformed global equities over the year to date. Similarly, in the US, stocks with China and international exposure have sharply outperformed the overall market over the last two months, and this trend has been evident in Europe as well.

Over the longer term, for the rally in risk asset prices to be sustained, we will need to see signs of global economic growth stabilizing.

This is especially pertinent for Emerging Markets (EM) assets (both equities and credit), whose performance has significantly lagged US assets since 2Q 2018.

This EM underperformance was driven by concerns over rising rates, a strengthening USD, trade fears and, most importantly, concerns over slowing EM growth – particularly in China.

In the 10 distinct episodes of EM and US divergence from the 1980s to present, we found that EM underperformance can last between 89 to 219 days, and that an improvement in EM economic growth was the main factor that drove EM assets to subsequently out-perform and close the gap.

The largest component of EM growth is China. While Chinese economic growth continues to slow, we expect to see some stabilization in 2H 2019.

There are emerging signs that point to this. For instance, Chinese total social financing (TSF) growth surprised on the upside in Jan 2019, growing 10.4% year-on-year and rebounding for the first time in 18 months.

China’s economic growth is strongly driven by credit creation, and the last two times we saw TSF growth rebounding was followed by a rebound in China’s GDP growth 1 to 2 quarters later.