Forward thinking

On this day 52-years ago, Look Back in Anger opened at the Royal Court Theatre on London’s Sloane Square. One critic has called this the birthday of modern British theatre. The play is a rather depressing portrayal of an unhappy marriage, but it did inspire one of the funniest headlines ever written, in the satirical magazine Private Eye: “Book Lack in Ongar”. It concerned a strike by library staff in Essex.

With developed market equity flows now at their highest level over the last month since July 2007, it seems that institutional investors are looking back with fondness rather than anger. Those heady pre-credit crunch days seem a long time ago. However, the strength of flows is also a clear indication that investors are looking through the current crisis and can see happier times ahead. Meantime the Vix Index of volatility has fallen to levels last seen when the Dow Jones Industrial Average and S&P500 briefly touched all time highs on October 9^th last year.

Flows into developed equity markets over the last month stood in the 87^th percentile (only higher on 13 percent of previous monthly periods in the eleven year history of the Cross-border Equity Flow Indicator). What is equally noteworthy is that flows last July were beginning to lose momentum. The weekly and fortnightly readings were sharply lower. That is not true of the current period. More recent flow readings remain very strong.

The Regime Map is used by the strategy teams at State Street Global Markets to describe the pattern of cross-border equity flows and the risk appetite of institutional investors. It remains in Leverage (see Chart 1). This is the fourth consecutive month of Leverage, one of the most risk-seeking of the five regimes anatomized by the Map. In hindsight the emergency rate cut in January by the US Federal Reserve proved to be a watershed moment. Since then institutional investors have slowly ratcheted up risk-seeking.

Across markets flows have both broadened and deepened. The tenor of sector flows has become gradually less defensive. For example, there is now tentative buying of IT and the selling of Consumer Staples has intensified. The measures taken by the authorities to boost liquidity may not have ended the credit crunch. The latest US Senior Loan Officer Survey shows that lending standards continue to tighten and interbank rates remain at historically elevated spreads above policy rates.

However, these spreads are narrowing and investors seem confident that a systemic crisis has been averted. The most consistent global theme in flows remains the continued buying of Financials where valuation levels have been dragged down by bad news and red ink. Markets are rewarding this risk-seeking behaviour. The MSCI World Index has rallied 12 percent since its March lows. In FX markets high yielding currencies such as the Brazilian real, South African rand and Turkish lira have been outperforming and the low yielding yen and Swiss franc have been underperforming.

Leverage has been the most stable of five regimes. Looking at the past history of the Regime Map, there is a 72 percent chance that it remains in Leverage next month. In fact, after the bursting of the TMT bubble and the short-lived US recession in 2001-2002, the Map stayed in the Leverage regime for eleven months between May 2003 and March 2004. The FTSE100 rallied through 4000 that May and began its relentless march to its recent high of 6754 reached in July last year.

Despite this, the overall tone of news coverage at the time remained gloomy. There was talk of a “jobless recovery” in the US and central bankers, especially Alan Greenspan, were fretting about the curse of deflation spreading from Japan. However, May 2003 was some 27 months on from the start of the previous US recession. Today the economic backdrop is very different. The economic data from the US has become slightly less supportive for those in the camp that says the country is already mired in a recession. But regardless the technical prognostications of economists, it is clear a slowdown has begun.

Investors seem more inclined at the moment to accentuate the positive. Monetary stimulus provided the initial encouragement to risk-seeking. Now the Fed is hinting that its work is close to over but investors are still sticking with their previous course. Deteriorating data from the economy has the most potential to dent risk appetite. Leverage regimes are generally associated with periods when leading indicators are improving.

That is clearly not the case in Europe, the UK, or US. The Fed has been the most proactive central bank in fighting both the credit crunch and an economic slowdown. With inflation threatening, others may be reluctant to offer the same medicine if their own economic cycle turns and second-order effects from the credit crunch feed through. If that is the case institutional investors may yet have cause to look back in anger.

Chart 1: Regime Map – Fourth consecutive month in Leverage

Source: State Street Global Markets