Market review: Are emotions overriding facts?

Market review: Are emotions overriding facts?

by Kristina Hooper, Global Market Strategist, Invesco Ltd., Invesco Canada

Global stocks moved higher last week, driven by a U.S. stock market that continued to advance despite a plethora of negative headlines and a growing likelihood that U.S. President Donald Trump’s legislative agenda will not come to fruition in 2017. In addition, U.S. stock-market volatility, as measured by the VIX Index, remains very low. It’s almost as if U.S. stocks have a Teflon-like coating around them, shielding them from the brunt of negative news. But why?

U.S. stocks seem to have a ‘positive charge’ despite risks

It seems clear that the U.S. stock market is shrugging off concerns over geopolitical risk and is emphasizing other factors instead. Certainly, the positive earnings situation has played a role in propelling stocks higher. In addition, I would argue that very accommodative monetary policy is also helping. Expectations of another rate hike this year have recently decreased, which is supportive of a “risk on” stance given the backdrop.

I also think there is something else at work. In psychology, there is a concept known as the “valence effect.” Valence refers to the positive or negative emotional charge an entity possesses. And the “valence effect” is the theory that people have a tendency to overestimate the chances of a positive outcome versus a negative outcome. This can be particularly true in certain circumstances where there is already a strong positive bias. Because the executive and legislative branches in the U.S. are of the same party for the first time in many years, and because the administration has laid out a largely pro-growth agenda, the U.S. stock market has become positively charged. Support for this view can be found in the significant improvement in “soft data” in the U.S., indicating very positive sentiment about the U.S. economy. It will be difficult to alter this positive charge that the stock market currently possesses.

But that doesn’t mean there is no risk in the market. After all, continued accommodative monetary policy is not assured in the U.S., with several unfilled Federal Open Market Committee (FOMC) seats and the very significant likelihood that Federal Reserve Chair Janet Yellen will be replaced early next year. (It is something of a head-scratcher to remember the market’s positive reaction to Chair Yellen’s Humphrey-Hawkins testimony earlier this month given that she is probably a lame duck.) And then there are U.S. growth expectations: The International Monetary Fund downgraded its growth expectations for the U.S., from 2.3% to 2.1% for 2017, and from 2.5% to 2.1% for 2018.

And while the U.S. stock market and the VIX Index suggest there is an absence of fear among investors, other indicators suggest otherwise. For example, the 10-year Treasury yield is often viewed as a better indicator of fear than stock market behavior, as Treasuries are viewed as a “safe haven” asset class. Last week we saw an increase in demand for Treasuries, which sent the yield on the 10-year Treasury bond lower. In addition, the price of gold rose last week just as Special Counsel Robert Mueller expanded his probe into Russia’s involvement in the 2016 U.S. election. Both are signs that there is some underlying fear in the U.S. stock market.

Because the valence effect is emotional, there are times when it may not sync with fundamentals. In my view, positive emotions may have driven up U.S. stock prices beyond where they should be based on the headwinds we discussed above. That doesn’t mean that U.S. stocks will fall soon – but I believe that they are becoming more vulnerable.

But in Europe, we may be seeing the opposite situation at work.

In Europe, positive changes aren’t inspiring much optimism

The European Union (EU) is in a very different place than it was more than a year ago when, to paraphrase Mark Twain, news of its death was greatly exaggerated. At that time, the United Kingdom (U.K.) had voted to exit the EU, growth was low and pundits were guessing which country would exit next. But much has changed since then.

I would argue that, in particular, the initial successes of French President Emmanuel Macron have created excitement not only about the potential for improvement in the French economy, but the potential for reform in the EU. And growth prospects in general have improved. Just last week, European Central Bank President Mario Draghi made some positive comments on the eurozone economy. This was followed up with improved projections for growth from the International Monetary Fund (IMF): The IMF boosted its growth expectations for 2017 for the eurozone to 1.9%, up from 1.7% in April.

As the IMF explained, “Growth projections for 2017 have been revised up for many euro area countries, including France, Germany, Italy and Spain, where growth for the first quarter of 2017 was generally above expectations. This, together with positive growth revisions for the last quarter of 2016 and high-frequency indicators for the second quarter of 2017, indicate stronger momentum in domestic demand than previously anticipated.”

However, European stocks are not acting very positively and showed weakness last week.

The different prospects for the U.S. and the eurozone may be illustrated by recent movements in their respective currencies. While the dollar has shown weakness, the euro has moved higher. Interestingly, in the U.K., the pound sterling experienced its worst week against the euro in about nine months. The U.K. is clearly facing diminished expectations as the realities of Brexit set in. A very public debate about the exit terms is unfolding in the media while major companies are making plans to move at least parts of their businesses out of London to EU cities such as Frankfurt. In brief, while there was a positive valence to the U.K. economy and U.K. stocks last year, it seems that has dissipated. But it has not made its way to continental Europe – at least not yet.

Takeaways for investors

This type of environment provides a reminder of the importance of diversification. While U.S. stocks may continue their gravity-defying rise, they are becoming more exposed, given that headwinds are being ignored and U.S. stocks haven’t experienced a correction of more than 5% in the last year. Keeping allocations in check through regular rebalancing and being selective about identifying opportunities will be critical going forward, in my view. I also believe that eurozone stocks could be a good complement to U.S. stocks, with the potential to move higher as sentiment becomes more positive. And we can’t ignore emerging markets stocks. If central banks, particularly the Fed, stay “lower for longer,” emerging market stocks may benefit.

This need for broad diversification extends to the fixed income sleeve of portfolios, as exposure to areas such as emerging-market bonds may provide benefits to the overall risk/reward profile of the portfolio. Finally, alternatives can also play an important role in this market environment. I’m particularly focused on market neutral strategies given the potential for disruptions going forward.

Looking ahead

Looking ahead, we will be paying close attention not only to earnings season and the many earnings reports coming out this week, but also to this week’s FOMC meeting. While the Fed is very unlikely to take any actions at this meeting, we will want to scrutinize the language in the announcement, specifically the discussion on inflation. If the FOMC begins to show signs it doesn’t think recent lower inflation is entirely transitory, that may indicate the U.S. will be “lower for longer.”

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