Has the outlook for equities fundamentally changed since the US stock market hit its latest record in late January? In the early weeks of this year, markets climbed a mountain of optimism, fuelled by a faith in synchronised global growth and ongoing loose global monetary conditions. Three weeks into 2018, the S&P 500 had raced up 7%, MSCI Europe was 3% stronger and Japan’s Topix had advanced 3%.
Confidence has since eroded. Fears that growth surge may be giving way to a global stalling are undermining the sunny premise that had powered markets higher.
If the Federal Reserve looked set to normalise rates gradually alongside a global economy that was still picking up steam, then the earnings outlook would dominate, bolstering equity prices. But the cracks in the growth story that have punctured confidence in recent months make it more difficult for investors to shrug off the US central bank pushing the discount rate higher.
These cracks are mostly evident in Europe. After a phenomenal (if long awaited) recovery in activity last year, the business surveys hit a bit of a rut in March. That left investors wondering if this weaker economic data was a blip or the sign of a peak.
Menacing weather might be contributing to the underwhelming figures. The ‘Beast from the East’ didn’t only bring the UK to a standstill in March. The cold snap affected business as far south as Spain.
But the most likely explanation for the downturn in sentiment on the continent was the combination of a euro-dollar exchange rate travelling rapidly through $1.26 (with all the surrounding chatter of a move to $1.30), and investors fretting over a looming trade war. Prospects were hardly looking up for the eurozone’s exporters – which are responsible for a hefty 47% of GDP.
We’ve seen similar aversion to rapid spikes in the euro in early 2011 and early 2016. In both instances, the business surveys suffered a setback.
But as we move through the coming weeks, exporters may have more grounds for optimism. The euro-dollar rate is now back below $1.20, in part because the European Central Bank has made it abundantly clear that ‘patience and persistence’ is required with its ultra-loose policy.
Trade war fears may also moderate. As the US mid-term elections approach, history reminds us that as voters go to the ballot box, an incumbent president could really do with low unemployment and rising stock prices. The stock market has made investors verdict on a global trade war clear in recent weeks. It may soon be in Donald Trump’s political interests to dial it down.
China’s president Xi Jinping has indicated he is willing to discuss China’s intellectual property restrictions, which act as an impediment to foreign business. If the negotiations reduce these barriers to entering the Chinese market, this could be a boon not just for US companies but businesses globally. The end result of this dispute could be more, not less, global trade.
This would lift the sentiment of Europe’s exporters and contribute to the virtuous cycle on the continent of more jobs, happier households, more spending and more optimistic companies willing to employ and invest. On the latest data, eurozone employment growth is running at an annual rate of 1.5%, the exact same rate as the US. That is a firm foundation for ongoing solid growth in the eurozone in excess of 2%.
A rebound in corporate sentiment in Europe, alongside robust earnings, should revive investors’ confidence that the global economy is on track to record another year of strong growth. Robusy global earnings should outweigh a rising discount rate. Remember that whilst the US ten-year Treasury yield has risen by almost 70 basis points over the past year, expectations of S&P 500 earnings in 2018 have risen from 12% to 20% over the same period.
Given the reaction to rising yields in recent weeks, one is left wondering whether some investors seem to need low interest rates to be convinced to buy equities. But low interest rates were in place to counteract weak growth and low inflation.
The Fed’s glacial but concerted moves to raise rates signal their confidence that the economy no longer needs the crutch of low interest rates. The fact that longer-term rates are also rising suggests that some of the structural concerns – including low productivity and risks of deflation – are also dissipating. This is good news.
Despite the market jitters, the cracks in the global growth story don’t look fatal. Indeed, an environment of robust operating leverage, corporate pricing power and more normal interest rates is still a healthy backdrop for holding equities.
Karen Ward is chief market strategist for the UK and Europe, JPMorgan Asset Management
