It is easy to be a pessimist when the world feels so bleak. Geopolitical threats have not been this severe in decades and are bound to intensify amid rising momentum in the shift from a unipolar system based on US leadership to a multipolar one in which a diverse group of powers compete for influence.
While the United States remains the undisputed financial hegemon, it is also the main source of volatility in markets as the Federal Reserve – the world’s most influential central bank – works to determine whether it has kept interest rates high enough for long enough or has held them too high for too long. The Fed’s insistence that its policies are “data dependent” will continue to fuel uncertainty due to the bumpy path towards low inflation.
Other threats include the acute structural challenges facing China’s economy, the unpredictable outcome of the US presidential election in November and, crucially, the possibility of an unforeseen systemic financial shock or “black swan” event which shatters confidence in the global economy.
Yet despite all these risks and vulnerabilities, a sense of optimism permeates markets. While it is often hard to disentangle complacency from bullishness, sentiment has not been this upbeat since the end of 2021, according to the results of Bank of America’s latest global fund manager survey.
The MSCI All-Country World Index, a gauge of global stocks in developed and developing economies, has gained 25 per cent since October 27 despite a sharp decline in the first half of April because of concerns the Fed will struggle to ease its monetary policy this year. Even a version of the gauge of global equities that excludes the popular technology-heavy US market is up 19 per cent.
The Hang Seng Index is displayed on an electronic monitor in Central on May 13. Photo: Sam Tsang
According to Bloomberg, 14 of the world’s 20 largest stock markets hit record highs recently, including in the UK, Germany and India. Moreover, it is not just equities that are performing well. Spreads, or the risk premium, on US investment grade and high-yield corporate bonds are now lower than they were in January, when markets expected the Fed to cut rates aggressively this year.
Markets have been climbing a wall of worry for some time. This has accentuated the disconnect between high asset prices and fragile economic fundamentals. It has also exposed flaws in the prevailing narrative of a “soft landing” for the global economy.
Nearly a third of respondents in the Bank of America survey expect a “no landing” outcome, mainly because of the persistent strength of the US labour market. Should such a scenario materialise, not only would the Fed be unable to cut rates, it might have to raise them further. This would deal a hammer blow to stock markets the world over and may explain why higher-than-expected inflation is far and away the biggest tail risk, according to the survey.
However, tail risks are low-probability events. While investors should be on guard against such threats, they should not overreact to them. There is always a possibility of a sudden meltdown in asset prices, but the fear of missing out on a “melt-up” – which is already happening in US tech stocks – is far more potent.
Goslings and their parents swim in the Main river with the European Central Bank in the background, in Frankfurt, Germany, on May 26. The European Central Bank is expected to start cutting interest rates next month. Photo: AP
The big question is whether the upbeat mood in markets is warranted. Four factors suggest the case for optimism is stronger than many realise. First, while it is unclear when the Fed will ease policy, borrowing costs in the leading economies are coming down. Next month, the European Central Bank is almost certain to become the first major Western central bank to start cutting rates. The signalling effect of looser policy will help underpin the rally.
Second, growth is proving stronger than expected in more vulnerable economies. In the euro zone, which was on the cusp of recession for much of last year, a weighted average of data on manufacturing and service-sector output expanded for the third straight month in May. While the industrial sector continues to contract, the data-beating expectations are what matter to markets.
Japan, which has long struggled to banish deflation, feels confident enough to raise rates as the prospects for wage growth improve and the sharp fall in the yen stokes inflation. Even in China, more forceful measures to stabilise the stricken housing sector have contributed to upward revisions to growth forecasts for this year.
Third, investors love Nvidia, the chip maker that is the biggest beneficiary of the boom in generative artificial intelligence (AI). The firm’s market value is now higher than Germany’s entire stock market.
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Apple supplier Foxconn to build ‘AI factories’ using US hardware leader Nvidia’s chips and software
Apple supplier Foxconn to build ‘AI factories’ using US hardware leader Nvidia’s chips and software
According to Bank of America, Nvidia alone accounts for 25 per cent of the return of the S&P 500 this year. Another 25 per cent is attributable to the other six members of the “Magnificent Seven” group of large US-based tech firms. While some investors fret about concentration risks and see another tech bubble in the making, most are convinced AI will prove far more useful and transformative than cryptocurrencies.
Fourth, and perhaps most importantly, investors are looking for reasons to be optimistic – an underappreciated driver of sentiment. A glass-half-full view is a strong counterweight to fears about the global economy and markets.
To be sure, some risks, especially higher-than-expected inflation and the US election, are being underestimated. Yet, while the wall of worry may be steep, investors continue to scale it.
