Two articles published overnight indicate that the period of central bank omnipotence has ended. The Daily Telegraph carries this commentary on the ECB exhausting its ability to improve the Eurozone economy and this piece about the need for central banks to continue to project omnipotence, whatever the reality. One of our favourite analysts, Ben Hunt, has already declared that central banking influence is on the wane.
Our recent blog on the logic of investors doubling up equity positions through the option market concluded that this strategy was rational when central banks are the primary influence over stock markets. It stands to reason that if this influence is on the wane, then the risks to equity exposure are mounting.
At OTAS we spend a lot of time looking at the indicators that may inform investors about a change in trend. One popular indicator is the level of credit default swaps, shown here for the median US large cap.
US Large Cap Median CDS
The lowest level of risk for US companies on this measure was June 2014. We have noted that this corresponded to the approximate peak in global export volumes and that economic momentum has deteriorated subsequently. The Fed indicated its taper strategy in December 2013 and officially ended bond buying in October 2014, but it was not until April 2015 that the cost of credit for US corporates began a meaningful rise. Credit risk has returned to its average level and stalled. This may indicate a reluctance to believe that the Fed can raise interest rates meaningfully.
US Large Cap Median Implied Volatility
Implied volatility is another favoured measure of risk. This also reached a trough in the summer of 2014 and showed a more meaningful pick up from Q2 2015. The reduction in implied volatility since February however, is at odds with the CDS risk indicator. This may suggest that the actions of investors are supressing volatility without the same degree of support from central banks as in the past. This is either because corporate earnings are on a growth trajectory, or because a bubble is forming based on past behaviour by central banks.
US Large Cap Median PE
The PE valuation of US large caps is above its average range and on the verge of completing four weeks of decline from close to record highs this cycle. PE can fall due to rising earnings or falling prices and there is nothing to stop the two occurring simultaneously.
The situation in Europe sees the PE valuation of large caps at the very top of the average range. Relative to US stocks the valuation is mid-range, as shown below. The relative valuation has been rising since early July, which may be currency related. It does not, however, bear out relative rates of growth and is not factoring in that further ECB action may be detrimental to the economy, as suggested in the first article referred to above.
European Large Cap Median PE relative to US Large Cap
Our final chart shows the valuation of large cap UK stocks. This looks a lot like the US chart, albeit at slightly lower levels of PE. Short term positive EPS revisions are dominated by the Materials sector; much as Energy stocks dominate the list of most recently upgraded US shares. In Europe, ex the UK, without such a prominent resources sector, upgrades show no obvious sector bias.
UK Large Cap Median PE
The last month suggests that cracks are beginning to form in the equity bull market thesis. One rationale for this is that the power of central banks to influence stock prices is diminishing, perhaps at an accelerating rate. The bigger point is that monetary policy alone has been insufficient to drive an economic recovery that translates into corporate earnings rising as quickly as stock prices. One has to doubt that investors will afford politicians and fiscal policy the same perceived omnipotence as they have allowed central banks and monetary policy in recent years.
