U.S. equities remain steadfast in the wake of the surprise Brexit vote two weeks ago. Just look at the action on Wednesday and Thursday, as shares calmly recovered from early session weakness despite ongoing pressure on the European banking system.
The summer calm comes despite growing evidence that all is not well.
Italy's banks are in focus as politicians bicker over a possible bailout. The tailspin is catching the entire European banking industry, with Deutsche Bank (DB) collapsing well below its 2008-2009 financial crisis lows. In response to weakness in the pound sterling, more than five U.K. property funds have suspended trading and blocked redemptions as investors scramble to sell in anticipation of further currency-driven losses.
The fear is reflected in a collapse in the 10-year U.S. Treasury yield to a record low of 1.3 percent, undercutting the prior trough set in July 2012. Either the stock market is right and the situation will blow over just like the fiscal cliff, the taper tantrum, the 2014 Ebola scare and so many other scary events have during this bull market; or the bond market is onto something serious.
Catalysts for the malaise in fixed income include fears over the economic fallout from Brexit, political risk that the likes of Spain and Portugal could look to exit the EU as well, and the realization that any new monetary policy stimulus effort is likely to further reduce long-term interest rates and thus further pinch bank profitability.
Moreover, the drop in U.S. yields is in sympathy with an even deeper collapse in global government bond yields, with more than $10 trillion in sovereign debt now trading at negative interest rates. Countries with rates below zero include Germany, Japan, Switzerland and the Eurozone as a whole.
Moving forward, watch for the weakness in European banks — which U.S. financials are doing their best to ignore — to deepen. Over the past year, shares of Italy's UniCredit are down nearly 70 percent, the Royal Bank of Scotland is down about 60 percent and Credit Suisse and Barclays are down 50 percent. The U.K. fund freeze could also have a chilling effect if spurned investors sell other assets in an attempt to reduce their exposure to a weakening pound.
Also keep an eye on the ongoing surge in precious metals, which along with plunging long-term interest rates indicates ongoing nervousness in the global financial system.
While American stocks are close to record highs, global stocks are being routed. Germany's DAX is down more than 10 percent from its April high and nearly 24 percent from its early 2015 high. Japan's Nikkei is down nearly 30 percent from its 2015 high and is in the midst of a retest of its February low.
As for equity market sentiment: The latest Investors Intelligence polls are flashing 47 percent bulls to less than 25 percent bears. Confidence in equities — in the belief that the central banks can and will squash any selloff attempt — remains in fever territory. We're about to see whether or not that confidence is justified.
According to Goldman Sachs economists, the outcome will depend on whether or not the Federal Reserve does, in fact, rate interest rates this year. Current market odds put those chances at just 10 percent vs. the bank’s own estimate of 70 percent. If it happens, a rate hike would badly destabilize stocks. Much depends on the course of inflation — driven by crude oil, housing, job gains and possible wage hikes — in the months to come.
I feel compelled to mention old-fashioned fundamentals, despite the fact no one seems to care about them anymore. Stock market valuations are growing increasingly demanding amid a corporate earnings recession that will likely stretch to five quarters when results for the April-to-June period are released later this month. According to FactSet, analysts are looking for S&P 500 earnings to decline 5.3 percent from last year. If the earnings decline does continue, it would mark the first five-quarter-long downturn in profitability since the 2008-2009 nightmare. And the drag from weaker energy prices and a stronger dollar look set to keep going. Watch for executives to add Brexit concerns to the list of excuses for declining earnings.
Gluskin Sheff economist David Rosenberg sees parallels between what's happening now and the slow-burnout of bull markets in 2007 and 2000, citing a rollover in forward-looking economic data. He notes that the S&P 500 hit its last cycle high in October 2007 "even though cracks had been emerging in the mortgage and housing markets for nine months at least." And the market peaked in September 2000 "even though the Technology sector had been seeing its bubble burst for at least six months prior to the peak."
Going back to the 1990, he notes that commercial and residential real estate faced trouble for more than year before stocks woke up to the problem.
He compares the S&P 500's three-year-long sideways skid to Wile E. Coyote running off the edge of the cliff in a myopic pursuit of the Roadrunner, floating in the air as if by magic. But eventually, he looks down. And gravity ends the fantasy.