Citi: Expectations, Not Data, Are Driving Stock Prices

The return of the hammock formation.
Source: Hammacher Schlemmer via Bloomberg

Legend has it that John Maynard Keynes once said "when the facts change, I change my mind. What do you do, sir?"

For economists, facts have largely been staying the same—it's their minds that have been changing.

That's how Citigroup Inc. Managing Director of Global Strategy Mark Schofield describes the seasonal interplay between the data flow, economists' expectations, and stock market performance in a note to clients that affirms how perception is more volatile than the underlying reality.

"We think that the most important issue for markets over the next few months is going to be the level of growth relative to expectations, rather than the level of growth per se," writes the strategist. "The underlying trends in the data have not been particularly volatile; it is the expectations that have been moving."

For instance, a bevy of economic indicators — including the Philly Fed Coincident index, initial jobless claims, non-farm payroll growth, job openings, and annual home price appreciation in major cities — have remained rather steady over the past year, while economic surprise indexes have shown a much higher degree of volatility.

Schofield notes a tendency for Citi's U.S. economic surprise index to disappoint at the start of the calendar year before starting to improve at the midpoint, a pattern that The Globe and Mail's Scott Barlow has deemed to be a 'hammock' formation.

Screen Shot 2016-04-20 at 12.17.24 PM
Source: Bloomberg

Somewhat counterintuitively, however, risk assets tend to perform better at the start of the year amid underwhelming data than when economic performance exceeds expectations around the middle of the year.

One reason, Schofield hypothesizes, is that subpar data prompts markets to anticipate more monetary stimulus or a slower withdrawal of that accommodation — in other words, bad news is good news. This line of reasoning also meshes well with a report from Deutsche Bank AG Chief Global Strategist Binky Chadha, who found that trends in the surprise index tended to provoke a monetary policy response from the Fed.

Schofield's other argument is that the seasonal pick-up in these surprise indexes and decline in equity prices have been prompted by the same thing: falling expectations.

"The improvement in the Economic Surprise indices has often been a result of deteriorating expectations rather than improving data," asserts Schofield. "This deteriorating sentiment has also manifested itself as a weakening in risk appetite."

In 2016, as the above chart shows, Citi's U.S. economic surprise index had a better than typical start to the year. The strategist chalks this up to economists incorporating the 'residual seasonality' that's depressed first-quarter growth acutely in recent years into their estimates this time around.

As such, Schofield thinks that another summertime swoon might not be in the cards for 2016, thanks to the atypical capitulation seen in the first quarter and the ebbing of deflationary fears in light of the rebound in commodity prices.

This leaves him cautiously optimistic on the outlook for equities.

"We can probably look for risk assets to maintain their somewhat better tone, although it is hard to envisage a major move higher unless we actually get stronger growth," he concludes.