The problem for stocks: fewer positive surprises

Markets are a function of reality meeting expectations. Russ discusses why the expectations are outpacing the reality.

By virtually every metric, the U.S. and most of the major economies are accelerating for the first time in many years—and in a coordinated fashion. A further bit of good news: Unlike last year, U.S. economic expectations are improving faster than the rest of the world. During the past six months, 2018 growth expectations have risen from 2.3% to 2.7%, significantly above the post-crisis average.

However, while both hard data and expectations are improving, in recent months the latter, expectations, seem to be improving faster than the former, hard data. In other words, economic releases are no longer beating expectations as frequently or by the same magnitude as was the case in the fall.

As “beats” have slowed, economic surprise indexes have weakened. The U.S. Citi Economic Surprise Index has been slipping of late. The trend is even more evident at the global level. The Citi Major Economies (G-10) Economic Surprise Index has given up more than half the fall’s gains and is on the cusp of turning negative, i.e. more negative than positive surprises, for the first time since early last fall (see the accompanying chart).


Why does any of this matter?

Markets are a function of reality meeting expectations. As with a single company, the more investors expect, the greater the scope for disappointment. Conversely, when investors are pessimistic and expecting bad news, even slightly less bad news can be a catalyst for a rally.

This tendency is evident in the data. Historically there has been a positive relationship between economic surprises and U.S. equity market performance. This relationship is even stronger when looking at a global (G-10) index of economic surprises.

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There are at least two ways in which economic surprises impact markets. Positive economic surprises are associated with a robust, or at least improving, economy. A stronger economy means better earnings and revenue growth. As such, stocks are more likely to climb when economic data is beating expectations.

In addition, when the economy is doing better-than-expected, investors tend be more optimistic, meaning they are willing to pay a premium for stocks, all else equal. Historically, valuations have been higher when global measures of economic surprises have been positive.

When good is not good enough

This is important as investors wrestle with the rest of the year. Although most forward-looking measures of economic growth appear solid, everyone already knows that. Given growing concerns over the Federal Reserve and the potential for a trade war, investors are counting on stellar earnings growth to power stocks higher.

While earnings will doubtless rise significantly in 2018, any disappointment will occur against a backdrop of real risks, particularly the risk of tighter monetary and financial conditions. In this environment, good may not be good enough if reality fails to meet and exceed already lofty expectations.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

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