Could do better?

6 April 2018

April and the second quarter of 2018 carried on exactly where March and Q1 had finished – volatile. The financial media made a big story out of the fact that markets had not opened the second quarter as poorly since 1929 – mostly missing to mention that the 2-3% April 2 decline was less than what markets staged during more than one day during March. And just as before, the recovery was just as swift the following day, and stock markets ended the week broadly where they had started.

The week’s erratic market movements appeared squarely the responsibility of Donald Trump, whose presidential threat and criticism of Amazon’s business model triggered another wave of selling in the US Tech sector, whereas his renewed trade war sabre-rattling towards China spooked markets globally. We cannot be entirely sure whether he now regrets having previously claimed bragging rights for the stock market highs in January.

What we do know is that there is a widespread suspicion that the US tariffs are intended as bargaining chips for trade negotiations with China, rather than the opening salvo for a lasting trade war. Why else would US stock markets have staged one of their largest one-day recovery rallies in recent history (on April 3), when members of the Trump administration suggested that markets were taking the threat of a trade war too serious.

For the moment, the fundamentally more important developments for near term market action are the latest macro-economic data releases on the state of the global economy and the outlook for the Q1 corporate results updates. The former brought little in terms of surprises versus expectations. The picture from around the world is that economic expansion has downshifted from rapid acceleration to ‘steady as she goes’, which we discuss and reflect in our third article this week.

Growth expectations have slowed slightly, but growth remains solidly positive and more important – synchronised across all major economies. It has been argued that stock market valuations are already pricing in a much more buoyant uptrend, but as we present in same article, we find that argument hard to follow, particularly since the stock market correction brought valuations back down to much less extended levels.

Analysts’ earnings expectations for Q1/2018 corporate results are making us a little more nervous. Not because they are indicating the same or bigger slowing than the top down macroeconomic expectations outlook, but on the contrary, because they are anticipating yet another strong pickup in corporate earnings results, particularly in the US. More extraordinary still is that analysts have been increasing their growth expectations over the course of the quarter, when normally they start overly optimistic and pare back as the actual announcement period draws nearer.

Should companies indeed be able to meet expectations of more than 17% annual earnings growth, then this should return upside momentum to stock markets. If they disappoint, it will at a minimum bring ridicule over the company analysts community, but has also the potential to trigger more market downside volatility. We are not quite sure what to make of the disconnect between macro and company data and will be pleasantly surprised if company analysts are proven at least partially correct.

The US trade dispute with China clearly has the potential to upset the current benign economic outlook. More likely is that both sides will engage in intensive negotiations that will lead to China changing its trading conditions under the WTO from its current emerging market status to more developed economy parameters as seems appropriate for the now second largest economy on the planet. Neither side has a particular interest in causing collateral damage to their respective economy, but there is clearly a possibility that 2018 will bear some of the cost necessary to achieve what could well be improved trading conditions going forward.

Following on from a first quarter that brought an end to the Goldilocks expectations environment, by reintroducing real cost of capital through gradually normalising interest rates and corporate bond yields, the second quarter could turn into a period over which the assumptions of this new, yet ‘old normal’ economic and capital market environment are being tested. We should therefore expect continued bouts of market volatility, where recent lows may be retested until the economic and corporate news flow confirms that just because more normal market conditions are returning, industry and commerce are not about to falter. As before, our expectation is that reality will turn out to be far more middle of the road than the extreme outlook scenarios being peddled at either end of the market spectrum.