27 April 2018
We are now over 90 days into this stock market correction and market action over the past week must have enforced the view of many lay investors that understanding what makes them rise and fall is beyond rational consideration. The ongoing Q1 corporate earnings results announcements are pointing to the strongest annual growth in corporate profits that most can remember – in excess of 20% – yet stocks fell on the good news.
How does that make sense?
The most widespread explanation was that company executives appeared to suggest it may be unreasonable to expect that profit growth could go any higher than this for the rest of the 2018. The term ‘highwater mark’ quarter made the round and thus fear of ‘cycle peak’ and ‘end of cycle’ was back. On the basis that further strong results announcements later in the week were greeted with rising stock prices, points to a different underlying reason: rising yields and a rising exchange rate for the US$ in their wake.
Yields of US 10 year government bonds (Treasuries) went through the closely watched 3% threshold. In the absence of renewed inflationary pressures it was initially positively interpreted as an indication that a growing number of investors are gaining confidence in further longevity of this economic cycle. Unfortunately, however, without further acceleration of growth, higher yields put pressure on equity valuations because they also serve as the discount rate for future earnings and the higher they are the lower is the present value of those future earnings in today’s valuations (more about this in the second article this week).
More attractive bond yields in the US could also increase the demand for the US$ and push the currency up against other global currencies (see the third article this week for more). This has in the past caused trade around the world to slow due to the greenback still acting as the global currency of trade. Furthermore, overseas revenue receipts of US multi-nationals (Apple, Amazon, Facebook et al.) would decline in USD terms.
So, maybe there is sense in the apparent market action madness after all. From our perspective, we welcome and are relieved that elevated earnings forecasts by research analysts are not being disappointed by corporate results announcements. That stock markets overall only slightly nudged upwards over the week is also welcome because it allows valuation levels to consolidate and indicates that January’s exuberance may indeed have been shaken out by the return of normal levels of equity volatility since February. Unless we join the brigade of overinterpreting and doom saying investment strategist, the current consolidation phase in equity valuations should be welcomed because it helps to rebuild the earnings base of share prices, while preventing overheating market conditions.
The 10 year treasury yields fell back to 2.96% by the end of the week, which may tell us that the 3% is not as much a watershed as some had suggested and therefore the bond market normalisation remains a far more gradual affair than many believed and still fear.
Before getting complacent on the back of these insights, it is worth noting the work of our research partners at MRB, who point out that a key characteristic of non-recession stock market corrections like the one we are experiencing has been that they have tended to bottom only after 3-6 months, with the turning point usually marked by the stabilisation of the upward trend in bond yields. On this basis and the fact that global economic growth is currently going through a slowing phase, there is good reason to remain vigilant over the coming months and watch yield curve developments just as closely as the many macro and micro economic indicators.
In other news, the Q1 GDP reading for the UK has confirmed our view as we presented over the past two editions of the Weekly that the UK’s economy has fallen back to much the same stagnation as its government’s Brexit negotiation progress. This is not entirely the result of the unsatisfactory Brexit position, but has just as much to do with the sudden slowing of the rest of the EU, which had recently counter-balanced the lack of UK domestic demand. In any event, a second rate rise in May by the Bank of England should no longer be expected.
The growth baton passing back to the US has come as a surprise, but may yet prove temporary and a return to more sustainable rates of growth than the Continent experienced towards the end of last year.
Geopolitical risks continue to hinge on US politics, but the bullying diplomacy style of ‘Trumplomacy’ appears to have yielded the desired result of forcing Trump’s geopolitical adversaries to the negotiation table. Progress in Korea and in trade negotiations with China appear to prove Trump’s tactics.
Unfortunately, from here onwards strategy, negotiating skills and detailed knowledge will determine success or failure. Looking at Trump’s trade policy team of highly opinionated but politically inexperienced business people and pseudo-academics we are not convinced that he can repeat his tax reform success where he could rely on the Republican dominated Congress to chisel out and push through the detail.
For the time being we are relieved that the Middle East tensions have not led to hostilities between Iran and Israel or any other hostilities as we described as imminently possible in last week’s edition.