Stocks are at record highs -- here's what one strategist thinks is going on, and what's next

After more than a year, stocks are finally at all-time highs again.

They were on track to hit this record right before UK voters chose to leave the European Union in June.

That decision was a surprise to investors, so when Britain voted to leave stocks sold off.

But just three weeks later, the benchmark S&P 500 index aced its closing and intra-day highs.

In a note on Tuesday, Alan Ruskin, global head of G10 FX Strategy at Deutsche Bank, wrote that the cloud has lifted on six key concerns investors had about the global economy.

“Since the most obvious manifestation of ‘risk on’, is the S&P break to new highs, US equities are probably the most direct places to participate in the ‘risk on’ trade,” Ruskin wrote.

“Ideally a weekly S&P close above the 2,135 previous high would clinch this crucial bull signal,” he said. The index climbed to as high as 2,155.90 on Tuesday.

Here are the six issues Ruskin identified:

  • The strong June jobs report released on Friday showed that the US economy is not spiraling into a recession.
  • The People’s Bank of China performed a “stealth devaluation” of the yuan to support its economy after the UK referendum. This showed that the bank can achieve a stable dollar/yuan rate without shaking up global markets, as long as it appears to be in control.
  • Brexit could be hugely damaging to the EU and the UK, but it has not proven to be so for the rest of the world.
  • The Italian banking crisis — characterised by a surge of bad debts — is small enough to be solved fairly easily by politicians if they agree on the right solution.
  • Japan’s fiscal policy, or at least its prospect, has excited markets and could serve as a key litmus test for how effective the alternative to monetary policy is. But even if this kind of policy to stimulate Japan’s economy flops, Prime Minister Shinzo Abe’s initiatives are back on the table following his ruling coalition’s majority win in Sunday’s elections.
  • Hillary Clinton has a solid lead in the polls, and that’s a plus for the status quo, following a massive political surprise like Brexit.

These are some of the main factors that have helped push the market to new highs this week.

But in the same note, Ruskin wonders how long this will last.

That’s because even as stocks have rallied to new highs, global bond yields, including those on US Treasurys, have tumbled to record lows. And despite the economy’s strength, investors are signalling they don’t expect the Federal Reserve to raise interest rates again until 2018.

“Something has to give — either the risk rally is hopelessly misplaced or Fed rate expectations are,” Ruskin said.

In other words, investors’ expectations for the Fed to remain accommodative with ultra-low rates paint a worse picture of the economy than the rally in stocks does.

“The US front-end looks extremely vulnerable,” Ruskin said, referring to short-term bond yields. “This is also the factor most apt to eventually slow/stop the risk rally and support the USD.”

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