Skip to main content

The key question for investors during market rallies is, “How long can it last?” To answer that, it’s helpful to examine the primary forces pushing markets higher.

A close look at the data shows that the year-to-date surge in North American equity markets – 11.7 per cent for the S&P/TSX Composite Index and 11.1 per cent for the S&P 500 – is almost certainly down to central bank monetary policy.

We know that earnings growth is not driving the rally. The domestic reporting season is just getting in to full swing but the almost-complete U.S. earnings season included significant reductions in profit expectations. U.S. earnings forecasts have been slashed to the point where first-quarter profits are expected to show the first year-over-year decline in three years.

Story continues below advertisement

The weakening global economy is also an unlikely candidate for primary driver behind the rally. The Citi Economic Surprise Index for the global economy (not shown) measures economic data against economists’ consensus expectations. A positive reading on the index indicates that the most important data points – the index gives higher weightings more to larger countries and more prominent reports such as gross domestic product and industrial production – are coming in above expectations.

Currently, however, the Citi index’s level is minus 23.7, indicating that global economic growth continues to disappoint.

The Goldman Sachs U.S. Financial Conditions Index explains recent market behaviour where earnings and economic growth can’t. Developed by prominent Goldman Sachs economist Jan Hatzius, the index measures the extent of easy credit. Since the end of September, 2018, the S&P 500 and the Financial Conditions Index has moved in tandem, as the accompanying line chart highlights.

What's driving the surge?

S&P 500

GS U.S. Financial Conditions Index

(right scale, inverted)

3,000

99.0

2,900

99.2

2,800

99.4

2,700

99.6

2,600

99.8

2,500

100.0

2,400

100.2

2,300

100.4

100.6

2,200

Sept.

2018

Oct.

Dec.

Jan.

2019

Feb.

Nov.

THE GLOBE AND MAIL, SOURCE:

SCOTT BARLOW; BLOOMBERG

What's driving the surge?

S&P 500

GS U.S. Financial Conditions Index

(right scale, inverted)

3,000

99.0

2,900

99.2

2,800

99.4

2,700

99.6

2,600

99.8

2,500

100.0

2,400

100.2

2,300

100.4

100.6

2,200

Sept.

2018

Oct.

Dec.

Jan.

2019

Feb.

Nov.

THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG

What's driving the surge?

S&P 500

GS U.S. Financial Conditions Index (right scale, inverted)

3,000

99.0

2,900

99.2

2,800

99.4

2,700

99.6

2,600

99.8

2,500

100.0

2,400

100.2

2,300

100.4

100.6

2,200

Sept.

2018

Oct.

Dec.

Jan.

2019

Feb.

Nov.

THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG

The chart shows a sharp deterioration in financial conditions that ended on Dec. 24, and then, thanks to dovish noises from central banks, a significant improvement in the market’s financial backdrop that is still continuing. (The Financial Conditions Index is plotted inversely – a rising line indicates loosening credit conditions – to better highlight the relationship with rising equity markets.)

There is a small amount of double-counting involved with the close connection between the Financial Conditions Index and U.S. equity markets because the S&P 500 is a component of the Goldman Sachs index. However, equities make up less than 5 per cent of the benchmark. The other components are the Fed funds target rate (4.4 per cent), the 10-year U.S. Treasury bond yield (45 per cent), the BBB corporate bond spread (40 per cent) and the broad trade-weighted U.S. Dollar Index (6 per cent).

Financial Conditions Index: key components 

Change, Sept. 30 vs. Dec. 31, 2018 Change, year-to-date
S&P 500-14.30%11.40%
10Y U.S. Treasury yield-40 bps-0.9 bps
Trade-weighted U.S. Dollar Index-13.00%-0.30%
BBB corporate bond spread+59 bps-33 bps

SOURCE: SCOTT BARLOW; BLOOMBERG

The connection between financial conditions and equity prices makes sense on a number of levels. Lower bond yields and borrowing costs translate to higher stock valuations. (Earnings growth looks better in comparison to lower, risk-free yields. Bond yields are also part of the denominator in discounted cash-flow calculations.)

Easier credit conditions also allow corporations to borrow funds through corporate bond markets at lower costs, which keeps interest expenses down and increases the attractiveness of debt-funded share buybacks.

Story continues below advertisement

The accompanying table compares year-to-date changes in the main components of the Financial Conditions Index with the last quarter of 2018. The BBB corporate bond spread – the difference in yield between BBB-rated corporate bonds and the equivalent duration government bond yield – appears to have played a major role.

In the last three months of 2018, the spread increased by almost 60 basis points, indicating significantly higher corporate borrowing costs and concerns about the creditworthiness of issuers – creditors demand higher yields to compensate for higher perceived default risks. In 2019, spreads have re-narrowed by 33 basis points as equity markets rallied (100 basis points equals one percentage point).

There are factors beyond financial conditions, earnings and economic affecting equity prices – the potential for a resolution of the U.S.-against-China trade dispute chief among them. I would argue, however, that central bank monetary policies, primarily the Federal Reserve but also the Bank of Canada, have been the dominant forces behind the market volatility of the past five months.

In short, in mid-2018 when markets expected a series of central bank interest rate hikes, equities went lower. When U.S. Federal Reserve chairman Jerome Powell and Bank of Canada Governor Stephen Poloz began signalling that monetary tightening was less assured, the rally began.

Back to our initial investor question, “How long can the rally last?” We can formulate a general answer. Markets are likely to continue higher for as long as central banks continue to make dovish, equity-accommodative comments about monetary policy. This will remain the case until a new positive driver for markets appears – signs that China’s efforts to stimulate their economy, or that corporate profits are set to improve would fit the bill.

Until then, financial conditions will be a key indicator for investors. Divergences between equity prices and any of the components of the Financial Conditions Index – bond yields and credit spreads in particular – should be taken seriously when plotting portfolio strategy.

Report an error Editorial code of conduct
Due to technical reasons, we have temporarily removed commenting from our articles. We hope to have this fixed soon. Thank you for your patience. If you are looking to give feedback on our new site, please send it along to feedback@globeandmail.com. If you want to write a letter to the editor, please forward to letters@globeandmail.com.

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff. Non-subscribers can read and sort comments but will not be able to engage with them in any way. Click here to subscribe.

If you would like to write a letter to the editor, please forward it to letters@globeandmail.com. Readers can also interact with The Globe on Facebook and Twitter .

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff. Non-subscribers can read and sort comments but will not be able to engage with them in any way. Click here to subscribe.

If you would like to write a letter to the editor, please forward it to letters@globeandmail.com. Readers can also interact with The Globe on Facebook and Twitter .

Welcome to The Globe and Mail’s comment community. This is a space where subscribers can engage with each other and Globe staff.

We aim to create a safe and valuable space for discussion and debate. That means:

  • Treat others as you wish to be treated
  • Criticize ideas, not people
  • Stay on topic
  • Avoid the use of toxic and offensive language
  • Flag bad behaviour

Comments that violate our community guidelines will be removed.

Read our community guidelines here

Discussion loading ...

Cannabis pro newsletter
To view this site properly, enable cookies in your browser. Read our privacy policy to learn more.
How to enable cookies