Investor sentiment turns down but not the economy

With the global equity bull market now around three or more years old, many investors are getting nervous about a possible turn in the market. However, economic indicators around the world provide few hints that the global economy is about to turn down any time soon.

Investor sentiment appears to have turned down of late. For example, Merrill Lynch's survey of global fund managers in February found them more cautious than in January, with cash levels rising to 4.1 percent from 3.5 percent in January and perception of recession risk rising. And according to Investors Intelligence's sentiment survey, the bull/bear ratio among investment advisors fell to 1.38 last week, close to the bottom end of its range over the past three years.

Of course, some contrarians would interpret this weakness as a bullish indication: Extremely weak sentiment on stocks is often a prelude to a reversal in sentiment that could drive stock prices higher.

Nevertheless, one should not ignore the fact that there is some basis for bearishness. Some bears have pointed to recent negative data in the economic indicators. For example, fourth quarter GDP growth in the United States was an anaemic 1.6 percent, new orders for US-made durable goods plunged 10.2 percent in January -- mainly due to a fall in non-defence aircraft orders -- homes sales in the US were also down in January, while consumer sentiment deteriorated in February.

Even in resurgent Japan, there have been blips in the stream of economic news, the most recent coming last Friday with the government reporting that the unemployment rate rose to 4.5 percent in January from 4.4 percent in December and salaried household spending in January fell by 4.7 percent from a year earlier and by 1.5 percent from the previous month.

And yet, analysts making a bear case by pointing to a weakening economy have a difficult task making it sound convincing because in reality, positive economic news have continued to predominate in recent weeks, especially on a global basis.

For example, indices derived from surveys of supply managers in most major economies were above 50 and rising for both manufacturing and services, implying accelerating economic growth. The All-Industry Output Index for February -- produced by JP Morgan together with research and supply organisations and combining service sector and manufacturing data from countries including the United States, the euro zone, Britain, Japan and China -- rose to 58.3 in February from 56.6 the previous month.

Other economic indicators reported have also been positive. The Conference Board's index of leading US economic indicators jumped 1.1 percent in February while sentiment surveys in Europe generally revealed optimism, with the Ifo index on German business confidence for example rising to a 14-year high of 103.3 in February from 101.8 in January.

Asset prices have continued to hold up, including those of homes in the US despite slowing sales. And this has probably helped prop up the main driver of global economic growth -- US personal spending rose 0.9 percent in January, even faster than a 0.7 percent rise in personal income.

However, these gains are increasingly being undercut by inflation. Although core US consumer prices -- excluding food and energy -- continued to rise moderately by 0.2 percent in January, overall consumer prices actually surged by 0.7 percent in January, bringing the rise over the past year to 4 percent, up from 3.4 percent in December.

It is a similar story in the euro zone, where the annual rate accelerated from 2.2 percent in December to 2.4 percent in January. Even in deflation-ridden Japan, core consumer prices excluding fresh food increased 0.5 percent from a year earlier in January and 0.1 percent if both energy and food are excluded.

Therein lies the real immediate risk to equities: higher inflation and interest rates. Indeed, last week, the European Central Bank raised interest rates by 25 basis points and gave indications of possibly more hikes to come, while Japan, finally out of deflation, is expected by many to end its ultra-loose monetary policy soon, possibly as early as this week.

The implications are not lost on fixed income markets, even in the US, where long-term yields had stayed stubbornly low in the past year or two in the face of Federal Reserve rate hikes. On Friday, the yield on the 10-year Treasury was 4.68 percent, up 11 basis points over the week.

And the implication of that on the stock market should not be lost on investors either. Stock markets usually do not like rising interest rates. In fact, stock markets often rise -- seemingly perversely -- in the face of weak economic data precisely because of the prospects for lower interest rates. Persistently low interest rates in the past few years have almost certainly been an important factor in sustaining the bull run in stock markets so far. However, with the global economy as strong as it has been, the global interest rate environment has been changing -- and looks set to change further -- in the tightening direction.

So the bears may yet have a case, but one that is made out of the strong economic data, not the weak ones.