Scared by a series of tweets and ever clearer signs of an impending or perhaps budding trade war, equity markets plummeted and credit margins shot up. Stocks and bonds did not disagree this time.
Will the trade war finally put an end to the long-lasting bull market? Are we in fact going to experience an all-out trade war?
These may be interesting questions, but they have a boring answer: We don't really know yet.
We do know, however, that there has been no shortage of warnings. We also know that these were not the first tweets to make markets tremble. In my view, then, this is the question of the month: Why such remarkable resilience? Why have financial markets kept brushing off most warning signs so far (at least up until now)?
To this question, fortunately, I believe there is an answer. It's plain and simple: because the rewards still seem to outweigh the cost.
“Why have financial markets kept brushing off most warning signs so far (at least up until now)?”
Arguably, the stock market reward may be measured by the earnings yield. In the long run, your stock market harvest is the fruit of your portfolio companies' earnings. The cost of money, probably less disputable, is the level of interest rates.
While half a year ago, all eyes were on the US Federal Reserve and imminent hikes in the Fed Funds rate, the longer-term picture is a vividly clear depiction of falling interest rates across geographies and maturities, brought about by key rate cuts at the short end and quantitative easing pulling down long rates.
This provided more headroom for stocks to rise: Price-earnings multiples rose, meaning that earnings yields fell as interest rates fell – but far less so. In all the years following the global financial crisis, earnings yields stayed higher above interest rates than in the preceding years. Scared by the crisis and unaccustomed to such low interest rates, investors demanded a margin of safety above their cost of capital.
That, I venture, goes a long way towards explaining the markets' remarkable resilience.
For some years now, it seemed that this margin of safety was slowly, but surely shrinking. Last year's market correction, in an ironic twist of fate, took care of that. That's the sweet thing about corrections: they keep improving the risk/reward picture.
So maybe May wasn't that bad for your financial health after all.
Finn Øystein Bergh
Chief Economist & Strategist
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