Easing-cycle optimism outweighs macro worries

Maxine Elliott    Philip Lawlor, managing director, head of global markets research, FTSE Russell
25 Jul 2019
Categories: General Market Analysis, Fixed Income, Financial Analysis, Investment Management, Regulation, Investor Education, Equity Investments

Country or region: Asia Pacific (Overall)

Equity markets have been rallying on the decisively dovish turn in Fed's and ECB's positioning and the optimism about the macro rewards it can bring. But a mismatch between market expectations and incoming economic signals persists.


Equity markets have been rallying on the decisively dovish turn in Federal Reserve and European Central Bank positioning and optimism about the macro rewards such stimulus may bring. But, as highlighted in our latest overview of current macro conditions, we note a persistent mismatch between market expectations and incoming economic signals.    

A challenging growth backdrop

Leading indicators and consensus forecasts suggest little to no improvement across the major economies next year. Current projections call for a sharp year-over-year slowdown in US GDP growth in 2020, putting it barely above the flat to marginally higher gains projected for the UK and the Eurozone.

Policymakers (and bond markets) are increasingly alert to the continued erosion in incoming economic data. The chart below shows the ongoing weakening in the Eurozone Economic Sentiment Indicator and the “economically weighted” US Institute for Supply Management (ISM) survey. The US survey blends the US manufacturing and services/non-manufacturing results through June and is weighted more to the latter sector, which accounts for nearly 85% of US output.

Although readings for both regions still signal expansion, they have fallen steeply over the past year. These surveys reinforce the latest composite leading indicators from the Organization for Economic Cooperation and Development (OECD), which also signalled further slowing growth across the major economies six months out.

Lackluster growth prospects are also suppressing market inflation expectations. The chart below plots the 5-year/5-year forward inflation expectation rates for the US and the Eurozone, the preferred and closely watched metric used by both Fed and the European Central Bank policymakers. Though this gauge briefly spiked upward for both regions following the accommodative messaging from their respective central banks in late June, they have resumed their downtrend since then.

Can the Fed fully meet market expectations?

The Federal Reserve and European Central Bank (ECB) have both made clear their willingness to adopt more simulative monetary policies. Fed Chairman Jerome Powell has all but promised to cut rates this month. But a bigger question is what happens next? Futures markets have priced in a 100bps cut in the Fed funds rate through 2020, starting this July, a far more aggressive trajectory than the Fed’s latest ‘dot plot’ is signalling (see chart below). This increases the scope of disappointment if central banks fail to meet the pace and magnitude of easing markets expect.

How much confidence should be applied to 2020 EPS forecasts?

Consensus 2020 EPS forecasts anticipate a robust recovery in growth off this year’s depressed levels (see chart below). EPS growth is expected to nearly quadruple year over year for the Russell 1000 in 2020 and to double for the Russell 2000. Asia Pacific leads this global earnings resurgence, with EPS projected to gain nearly 12% next year, a considerable turnaround from the steep decline forecast for this year.

However, analysts’ forecasts tend to be optimistically biased and to get trimmed as the year evolves, as has been the case this year. Consensus EPS estimates for this year have fallen more sharply than those for 2020, widening the ‘rebound’ gap between the two.

The combination of slower economic growth and declining inflation creates a headwind for revenue growth, posing a threat to operating leverage and the EPS growth outlook. As time elapses, the risk is that investors ultimately come to see the glass is half empty, not half full.

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