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Spring time from here?

18 April 2019

It is quite incredible how much investor sentiment has changed over the past 4 months. At Christmas, equity markets had suffered a decline from their September highs, which had many market commentators suggesting that the end of this prolonged economic cycle and investor bull market must now surely be imminent. Fast forward four months and stock markets are up 10-15%, have thus recovered most of their Q4 2018 falls and already there is talk about the potential of an equity ‘melt-up’ as Goldilocks conditions appear to have returned.

After such a roller-coaster ride in market sentiment, it is worth taking a step back and asking what are realistic expectations for the coming months. Just as we strongly suggested that equity markets had assumed too pessimistic a view back in December, we now guide investors not to get carried away and extrapolate forward the strong year to date return picture. Many of our research providers and market commentators more widely note that the primary cause of last year’s stock market sell‑off – another episode of the ‘bond market riot’ – has fully reversed after central banks signalled that they would not allow bond yields get out of hand. As a result, the bond markets for the time being no longer pose an imminent threat to the stock market or the economy.

However, the global economic slowdown which was part and parcel of the 2018 equity market derailment is still in full swing and has led to a considerable slowdown in corporate earnings growth. The first batch of Q1/2019 earnings updates have confirmed this expectation, even if they have come in less bad than the average forecast of analysts had predicted. Such ‘positive earnings surprises’ are very much the norm almost every quarter and therefore it would be premature to suggest that the usual 4-5% improvement in actual earnings provides additional upside. It merely means that earnings may not quite have shrunk compared to a year ago but are just about in positive territory.
More important than the backward-looking earnings announcements are management’s outlook statements and the wider economic news-flow. Management outlook statements were neither overly negative nor positive, but at least no longer speak of fears of significant activity slowdown. On the economic data side, the week provided a number of forward looking reports, which suggest that stock markets may not be wrong in looking forward more positively. This stems particularly from the latest Chinese figures, which suggest that the economy has begun to re-accelerate following a considerable 12 month period of slowing growth.

Europe’s figures are lagging the Chinese and indicate that here the trough may only be reached in this quarter. Nevertheless, given European economies’ dependence on a global trade volume revival, the good news from China initially gave European markets a boost.

With bond markets having stabilised, yields are likely to remain range-bound and well below last year’s peaks, which provides supportive financial conditions for the economy, but neither threat nor boost for equity market valuations. With economic conditions having stabilised as well and now displaying a mild upward trajectory, one could indeed describe this environment as somewhat of a Goldilocks environment, following last year’s far more stressful economic and market conditions.

Following the substantial market recovery, however, such an environment does not readily support the notion of continued strong stock market growth. Without accompanying corporate earnings growth, a further rally would simply lead to overvalued market conditions, which investors these days are particularly weary about – as the Q1 2018 sell-off proved.

It is therefore more reasonable to expect that, from hereon, 2019 stock markets should only grind higher in lockstep with improving corporate earnings expectation and this is likely to be gradual but slow. As always, there are upside and downside risks to reasonable expectation scenarios. As we discuss in a separate article this week, China’s activity rebound is real but perhaps not quite as forceful as some might expect.

And then there is always politics. Our cartoon at the top refers to Trump’s 2017 decision to considerably expand the burden of public debt in order to finance a fiscal stimulus tax break package, in the hope that the ensuing economic boost would lead to tax receipt increases that would eventually balance the books. His embarking on a trade war with China rendered such expectations null and void.

Having outmanoeuvred himself on the fiscal side, the only way he can now turn things around for the economy before he seeks re-election next year is by making trade peace with China very soon and then not embarking on another lengthy trade war with Japan and Europe. Similarly, hopes for a European economic rebound could be quickly quashed by a new breakdown in Brexit negotiations.

However, unless either of these political challenges ends in absolute disaster (which, given recent experience, seems less likely than it may have appeared at the end of 2018), then economic and corporate earnings growth should not be affected enough to send stock markets tumbling. The same cannot be said about the impact of another bond market riot, which, over the past six years, have always proven to be detrimental to stock markets. Since they have every time been caused by strengthening economic growth encouraging central banks into monetary tightening, we will be more concerned about and watching for any signs of too strong a rebound of economic activity over the coming quarters than mild growth disappointments.