If it's true that markets face slowing economic growth and lower corporate profits due to geopolitical uncertainty fostered by President Donald Trump's use of import duties as a weapon against a host of domestic challenges, then why is the S&P 500 index less than 2% from its late-April record?
Markets face three overlapping problems, according to Morgan Stanley analysts: Trade-policy tensions are taking longer to resolve than expected; economic data suggest a medium-term slowdown; and investor confidence that the Federal Reserve will ease monetary policy soon to support equity valuations.
"Hope around upcoming events later this month [G-20 meeting, Federal Open Market Committee gathering] may support markets in the very near term, but we think this peace is fragile as long as the 'three problems' remain," Morgan Stanley analyst Andrew Sheets wrote in a recent research note.
Stock valuations remain elevated though, with the S&P 500 index the Dow Jones Industrial Average and the Nasdaq Composite Index boasting gains for June of at least 5%, according to FactSet data. The trio of stock indexes also are substantially higher in the year to date. Despite a volatile stretch last month, the S&P 500 is just about 45 points from its all-time high seen on April 30, even as stocks headed lower earlier last week when Trump took the unusual tactic of threatening higher tariffs on Mexican imports if it doesn't help fix illegal immigration from Mexico into the U.S.
Deutsche Bank analyst Parag Thatte says the U.S. stock market appears not just oblivious to the risks that all other asset classes are worried about, but is interpreting bad news on the economic front as good news.
A good example of that was Friday's woeful jobs report, which saw employment growth in May create a meager 75,000 increase in new jobs, far lower than the 175,000 economists had estimated. However, equity gauges jumped on the prospect that the data may convince the U.S. central bank to at least consider reducing benchmark interest rates, if not stay on hold for longer, in the coming months. The FOMC next meets on June 18-19.
"Terrible news is once again tremendous news," Thatte wrote.
However, as fund flows data from EPFR showed again last week, most assets classes, except equities, are reflecting a contrary view, with S&P 500 funds seeing $10.3 billion in outflows last week.
Meanwhile, funds pegged to bonds again saw large inflows of $17.5 billion, extending a yearlong trend.
According to Deutsche Bank, this brings total bond inflows to $261 billion year to date.
Money-market funds also saw an inflow of $31.3 billion taking the total over the last six weeks to $138 billion as investors also flee to the safety of cash.
Federal-funds futures contracts, used by Wall Street to help gauge Fed policy moves, are now pricing in about four interest rate cuts by the end of 2020, according to CME Group Inc. data. Meanwhile, long positions in eurodollar rates futures are now at levels last seen around the European financial crisis in 2012, suggesting that traders are worrying about an end to the 10-year economic growth cycle and possible deflation.
Separately, gold funds-typically bought during times of uncertainty as stocks are sold - also saw the largest inflow in over two years last week and gold long futures trading on Comex also rose sharply to the highest in a year.
So which one of these markets or asset classes is wrong?
As Deutsche Bank's Thatte notes, short-term interest rates may be currently putting too high a probability on the economy sliding into recession.