Market Musings 220325: Just a correction, or a bear growling?

Market Musings 220325:
Just a correction, or a bear growling?

Podcast this week:
Extreme US bearish sentiment marks a tactical turning point
(click on link to listen)

Edmund Shing, Global Chief Investment Officer at BNP Paribas Wealth Management, discusses the bearish sentiment among US investors and the possible implications for future returns from US stocks.

Poking the bear?

The Trump presidency has certainly set the proverbial cat amongst the pigeons. Since inauguration on 20 January, Donald Trump has unleashed a maelstrom of Executive Orders that have created a record amount of geopolitical uncertainty in just 2 months.

The Economic Policy Uncertainty index published by Baker, Bloom & Davis illustrates just how extremely unpredictable the US and global geopolitical landscape has become, following a flurry of announcements regarding tariffs, the Department of Government Efficiency, NATO and the war in Ukraine.

According to the US version of this index, uncertainty today is higher than at any time bar the beginning of the COVID pandemic in early 2020.

Record surge in US economic policy uncertainty

Source: www.policyuncertainty.com

The result of this extreme unpredictability in US economic and foreign policy has been a plunge in the level of confidence of both consumers and businesses, as measured by recent surveys.

This plunge in confidence is beginning to weigh on both consumer spending and business investment, and thus on US economic growth prospects. This weakening growth outlook has transmitted to the US stock market, with an interruption in the bull market in place since late 2022. From mid-February peak, the S&P 500 index has fallen 8% and the Nasdaq 100 11% to date.

US stocks suffer from this collective loss of confidence

This still leaves the S&P 500 58% higher than its trough in September 2022, but it does sit below its 200-day moving average for the first time since late 2023. Back then, this breach of the moving average was quickly reversed. Time will tell as to whether the S&P 500 has rebound above this key moving average. If not, then we have to conclude that the current US bull market may have ended, and that a new bear market may have begun.

Not mirrored elsewhere in the world

We should note that this phenomenon is largely US-centric, and is not yet evident in other stock markets around the world.

European stocks (using the STOXX Europe 600 index that is a Pan-European index including the UK) remain solidly in an uptrend, boosted of late by the passing of the German defence and infrastructure spending plan. Eurozone stocks remain in a bullish trend, with the Euro STOXX 50 index only 2% below its recently-set all-time high.

European stock market close to all-time highs

We could equally look to Japan: Japanese stocks may have stalled since mid-2024, but again remain solidly above their 200-day moving average and have provided handsome returns to investors since mid-2022. The Japanese TOPIX index sits only 4% below its all-time high.

Japanese stocks look set to move higher

Even China is now responding to a combination of stimulus help from both the government and the Chinese central bank, in an effort to stabilise the local property market and support domestic consumption. Additionally, the arrival of DeepSeek and other generative AI large-language models from Alibaba and Baidu has boosted the Chinese tech sector, driving a big rebound in Hong Kong-listed Chinese stocks (represented by the HSCEI Hang Seng China Enterprises Index)..

Hang Seng China Enterprises Index +70% since start-2024

Rotation of stock market leadership

Within the US, profits have been taken in the former market leaders - the US mega-cap tech stocks, i.e. the Magnificent 7.

Magnificent 7 now 19% below December 2024 peak

As an example of this, look at Microsoft that has sunk 16% below its mid-2024 high.That said, it remains over 80% higher than its late-2022 low point.

Microsoft is trending lower

If we look at performance from the beginning of 2022, we can see that European Banks (represented by the EXV1 STOXX Europe Banks sector ETF) have far outstripped the Nasdaq 100 at +80% (not including dividends, which are generous in this sector) versus +21%.

European Banks still trend higher

Even in the Tech world, since September 2024 when the first round of Chinese stimulus efforts were announced, Chinese tech companies have far outstripped US tech companies in terms of stock market performance, boosted by the DeepSeek AI announcement in January…

Hang Seng Tech index wins hands down

What am I watching for confirmation of rebound or bear market?
High yield credit spreads

First, a word of caution. There is no perfect single indicator of impending economic recession or bear markets in stocks.

Of all the financial market and economic indicators that I have tested, the best single indicator is the index of US high yield credit spreads.

Ths US high yield credit index is an index of US corporate bonds which have a “junk” credit rating of BB or below. For note, corporate bonds rated AAA - BBB are considered investment grade and thus much lower risk. These credit ratings reflect the quality of a company’s balance sheet and cash flows, and thus the probability that an investor in the company’s bonds will receive their interest payments (coupons) and all of their initial investment back when the bond matures, without that company defaulting on these payments.

The high yield credit spread is the extra yield that an investor demands to own these high yield corporate bonds instead of an equivalent maturity US government bond, as compensation for taking on the extra risk of lending to these riskier companies as opposed to the US government.

In good economic times, the risk of default is lower as the economic backdrop is more favourable to these higher-risk companies, and thus the high yield credit spread is lower. In contrast, when the economy slows or looks like it might go into recession (economic contraction rather than growth), then this high yield spread rises to reflect the higher consequent risk of default, and an investor thus not receiving all of their money back when the bond matures.

How is the US high yield credit spread behaving at the moment? Well, it is rising to reflect the slowing US economy and the rise in economic uncertainty.

US high yield credit spread has risen, a little

Source: FRED database from the St Louis Fed

So according to this indicator, the risk to financial markets and to stocks has risen, with this credit spread at its highest in over 6 months at 3.2%.

But when we take a longer-term perspective, this rise in spreads seems very limited, at least so far.

High yield spreads remain very low by historic standards

In previous recessions (the shaded areas in the chart above), this credit spread index has surged well above 7.5%. Even at 3.2%, this high yield credit spread is still amongst the lowest recorded since 1997.

In the past, a move above 5% in credit spread has indicated widespread stress in financial markets, as observed in early 2022 post the Russian invasion of Ukraine. The current spread is actually one of the lowest readings recorded since 2008…

A strange way to start a recession

Ultimately, we are in a strange situation where this rising risk of US recession is entirely triggered (whether deliberately or not) by the actions of the Trump administration. This suggests that if President Trump wants to avoid a US recession, he has the means to achieve this by reducing peak economic uncertainty with his rash of Executive Orders and with his policy of raising tariffs on allies and perceived economic enemies alike, which has raised fears of a renewed surge in US inflation and erosion of household purchasing power.

For now, the credit markets suggest that we are seeing a stock market correction, rather than a slide towards a US economic recession. In addition, I expect further action from central banks around the world (US, Eurozone, UK, China) to reduce benchmark interest rates and thus the cost of borrowing for households and companies. This should boost both growth prospects and also liquidity in the global financial system, which should help stocks.

Let's see if the Trump administration worsens the situation or tries to reduce the pressure on the US economy in the coming weeks...

One last note: investor sentiment already extremely pessmistic, a good sign...

US investor sentiment surveys such as the weekly AAII investor sentiment survey below indicate extreme pessimism. These extreme bearish readings have only been rarely seen before, in 1990, 2009 and 2022. In the past, these extremes have proved good buying opportunities for the months that followed. 

When AAII retail investor survey extremely bearish, S&P 500 has rebounded

Source: SubuTrade via X

Best

Edmund