Risk appetite has been swinging from concern about slowing global growth and profits to optimism that aggressive Fed easing was just around the corner. Optimism appears to have won the day, at least for now. Hints last week of the Fed’s readiness to cut rates sparked a global equity rally, with US stocks notching new highs.
The Fed’s latest dovish nod joined similar remarks from European Central Bank and the Bank of England, reinforcing the prevailing assumption that central banks will always be there when markets need them. But such confidence can also breed complacency.
In this environment, bad news is being viewed as good news as it is seen to be forcing the Fed’s hand. That makes it particularly important, in our view, to take a clear-eyed assessment of the potential risks that could catch equity markets off guard. Our latest review of global equity conditions highlighted several of them.
Risk #1: deteriorating growth
Evidence that the global economy is slowing continues to mount. As the chart below shows, leading indicators from the Organization for Economic Cooperation and Development (OECD) are now at or near levels last seen at the height of the European debt crisis in 2012. A protracted trade war, a hard Brexit, an Italian debt crisis and/or a resumption of the US dollar rally top the list of additional threats to global growth.
Market inflation expectations have declined significantly since April (see chart below), and dropped even more following the Fed’s June meeting, further confirming a more downbeat global growth outlook.
Risk #2: dwindling earnings support
Falling economic growth and inflation expectations raise the risks to revenue and corporate earnings prospects. Indeed, as the chart below shows, earnings momentum has deteriorated in most markets since late 2018, with the uptrend in Russell 1000 and FTSE UK consensus 12-month-forward EPS forecasts leveling off while slumping elsewhere.
With their recovery from their May lows, forward 12-month price/earnings multiples for most major markets are now at or above their 10-year averages. Our analysis also showed that the rebound in 12-month-forward PEs since the December 2018 lows has come entirely from gains in the ‘P’, not ‘E’.
Risk #3: disappointing Fed action
While supportive of equities, the Fed-driven drop in the 10-year US Treasury yield to multiyear lows and deeper negative yields on other safe-haven equivalents paints a grimmer picture.
The latest Fed messaging and futures-market rate expectations-–which are now pricing in steeper Fed rate cuts than those forecast by the central bank’s rate-setting committee-–indicate that the easing cycle is likely to start from a significantly lower base than in the prior two cycles.
One risk is that the Fed disappoints by not moving as quickly or aggressively as the market expects. But lowering rates now also leaves the central bank with far less crisis-fighting headroom. Add in the bond-market signals coming from the recent inversion of three-month/10-year US Treasury yields, which has occurred before every recession over the past 50 years.
As always, the prognosis for equity markets requires thorough consideration of current valuations and evolving macroeconomic conditions. At this juncture, that includes answering the question: what might turn bad news into bad news again?
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