Is it a conundrum or a case of scratching harder to unearth what is actually going on? Apparently incompatible: bond yields have fallen dramatically, potentially foreshadowing a significant slowdown in economic growth or even a global recession, while equities have recorded double-digit gains in the past six months, reflecting... well, what in fact?
- Surveys of purchasing managers are pointing south
- But the US is leading the way on earnings optimism
- Market expectations of policy rate cuts by the Fed (and the ECB) are supportive
Lower yields, and with them lower interest expense, should be an equities-positive, although not necessarily so when yields are falling because general economic growth (= demand) is slowing or because inflation is absent, or so muted that it might as well be, which does little to stimulate sales. Looking at the prospects for growth, surveys of purchasing managers in the US are now pointing in the same direction as those in Europe were roughly a year ago: south. This concerns both the manufacturing and services sectors.
A slowdown hitting equities?
That shift presages a growth slowdown in the world’s largest economy. Indeed, growth in Europe did slow in recent quarters, but there was no recession. It now appears to be bottoming out again, led by France and Germany, the region’s main economies. Concerns remain over the course of Italy, and its tense relationship with Brussels, and even more so over the UK, where Brexit is still not a done deal and where departure from the EU without any clarity on the future relationship remains a real possibility.
Or earnings expectations?
So if growth is not that supportive of equities, is it earnings (expectations)? Earnings per share forecasts for S&P 500 stocks for the second quarter of 2019 may look poor, but that is partly because tax cuts boosted 2018 earnings. That effect is now dropping out of the equation. In addition, investors will be looking beyond Q2 2019. Indeed, Q2 2020 earnings are expected to show encouraging double-digit growth. As for earnings optimism, the US is currently leading the way, which has been reflected in equity performance and valuations. The rest of the world is lagging. That should all support equities.
Exhibit 1: Forecast earnings per share (EPS) growth (YoY)
Data as at 7 July 2019. No assurance can be given that any forecast, target or opinion will materialise. Source: FactSet, BNP Paribas Asset Management
And why are yields so low?
If low US Treasury yields are not necessarily pointing to a significant growth slowdown or rising recession risk, then what are they a sign of? Low inflation expectations on the one hand. Here, structural factors are at work such as technological advances and demographics (population aging). Low real yields on the other. This reflects market expectations of policy rate cuts by the US Federal Reserve (and the ECB, too). Those may have moderated slightly recently, after surprise US labour market strength, but they have not vanished.
Additional strength in the US economy, which has so far presented a mixed picture overall, could push rate cut hopes further out. That would be a risk to equities. Renewed tensions between the US and China over trade, as well as intellectual property rights and forced technology transfers, and slower than expected growth are further risks. If these materialise, equities would experience volatility and a correction. Bonds, in turn, might benefit from safe haven trades which would drive yields even lower. Such a trade-off would present no conundrum for investors.
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