- US S&P 500 chart flags up possible parallels after sharp dip
- Growth outlook: for US more promising than for the eurozone
- Recent US earnings reports have looked solid; eurozone disappointed
- Uncertainties abound… and stand in the way of a sustained bounce?
Looking at the sharp plunge in US equities as markets fell to their December 2018 low, one could be reminded of events in 2015-16 when equity markets saw a similarly steep drop and the beginning of a V-shaped recovery (see Exhibit 1). There are other parallels. We are again worried about the outlook for China and a steep fall in oil prices has been interpreted as a sign of a broader global slowdown in growth. Can investors assume that what happened then could be a useful model for what to expect in terms of a recovery now, especially given that the US Federal Reserve has signalled a pause, if not a halt, in its cycle of interest-rate increases? Equities gained 27% from their 2016 low in the 12 months after bottoming. The most recent bounce, from last December’s low, came in the form of a 16% gain. Does that leave another 10%-11% in terms of upside?
Any parallels or just disparities?To be able to assess the recovery potential, we should consider the differences as much as the similarities between the market and macroeconomic environment in 2015-16 and 2018-19. Most strikingly, both short- and long-term interest rates in the US are currently well above their 2016 levels. The market has already priced in a strong US economy with growth rates well ahead of those of other developed countries. Furthermore, the US central bank had – at least until recently –staunchly persisted in normalising monetary policy with growth holding up well and the labour market going from strength to strength. Economic growth and increased employment have both supported the stock market. By comparison, the difference between 2019 German two-year and 10-year rates and 2016 levels is modest. This reflects the flagging recovery of the German – and by extension, the eurozone – economy and a central bank hoping to tighten monetary policy, but not quite able to pull the trigger in light of a range of uncertainties including still muted inflation and weak exports. Accordingly, the year-to-date bounce in eurozone equities has lagged that of their US counterparts.
Pricing out what was priced into equitiesWhile the Fed is ahead of the ECB in terms of monetary policy normalisation – read, returning interest rates to levels that are more appropriate for this stage of the economic recovery – it now appears to have decided either that the risks to growth are such that normalisation can be put on hold, or else that inflation is likely to stay so muted that further interest-rate rises are unnecessary at the moment. This has taken markets by surprise: though fed funds futures markets showed scepticism that the Fed would actually raise rates by as much as the Fed’s own forecasts suggested it would, it was not anticipated the Fed would change course so quickly. With a pause in central bank policy tightening on the cards, the discount for still higher interest rates can now be taken out of equity pricing, creating upside potential for US shares. It is also worth noting that even if US interest rates were to rise further, the effect on company results might well be limited. This is because US companies are expected to deleverage, causing interest expense – the amount they need to pay in interest on loans – to stabilise even if interest rates are higher .This suggest that corporate leverage is not an obvious risk to the outlook for US equities. But haven’t the growth forecasts for the US economy been trimmed recently? They have, but only slightly, and the prospects for the eurozone look even less rosy. The bounce in US equities from the late 2018 dip has in part at least been driven by news of strong 2018 earnings and sales reports, and an underlying profit trend that still looks solid. A note of caution, however, can be seen in the guidance many companies have offered about the outlook for the rest of the year. These have been more downbeat than usual. In the eurozone, reports show that last year’s improvement in sales has disappointedly not been translated into profit growth on the whole.
One could well be sceptical about a repeat of 2015-16To sum up, we regard any market parallels between 2015-16 and 2018-19 as deceptive: now as then markets have fretted about the prospects for continued solid economic growth in China and falling oil prices. However, there are many differences such as the prospects for growth generally – including fears of a recession in selected countries – and the level of interest rates. Other uncertainties concern the chances of a US-China trade deal, the outlook for inflation amid tepid growth and low productivity, the durability and impact of economic stimulus measures in China, and the outcome of the Brexit process. There would seem to be plenty of factors that could thwart a continued bounce in equities and cause heightened volatility. Regaining the levels from October 2018 might well take until the end of this year.
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