Markets pause for breath
After a strong week for equities, this week we have seen a pause for breath, if not a small retracement in equities, although the bond market is continuing to make good progress.
Fear, greed and hope!
Whilst we have had our fair share of fear this year, last week we saw a combination of greed and hope fuelling equity markets.
Legal & General Investment Management (LGIM) sent me an excellent communication as to the market ‘bounce’. Tim Drayson, their Head of Economics stated “There was a euphoric market reaction to a modest downside surprise in core CPI (Core Price Index), relative to the LGIM forecast. We are seeing confirmation of the expected cooling in the price of goods, and we remain comfortable that as the economy weakens further and inflation pressures subside, the Federal Reserve (Fed) can slow the pace of tightening to 0.5% in December and then 0.25% in February.”
Good news on the face of it.
As LGIM point out, the market dynamic is often a tussle between ‘fear and greed’. They argue that last week it was ‘relief and hope’ that were the two most powerful emotions in play.
Relief because the US Core Price Index fell.
It has come in above market expectations on 8 out of 12 previous occasions. Markets had become accustomed to a process of constantly pushing back the timeline over which inflation would start its long march back towards the Federal Reserve’s target. We’d become accustomed to listening to reasons as to why inflation was transitory. In summary, we have become used to disappointment.
Which brings me to hope.
The last 12 months have been unusually brutal and bruising for investors in almost any asset class. Cash really has been king in an environment of rising bond yields and tumbling equity markets. With the recent weaker CPI reading, investors can dare to hope that the worst is over as we near the end of the rate hiking cycle. As Tim outlines above, we believe we’re now approaching that inflection point. But that doesn’t mean we’re embracing risk in a dash for the end of the year. As everyone knows, it’s the hope that kills you.
They think the market reaction in government bond yields is likely to prove more durable than the market reaction in equities: the stumble towards recession will reinforce the notion that we’ve seen the peak in yields, but also raise concerns about the corporate outlook.
Some discerning learnings from quarterly earnings
We have frequently commented that we expect to see a drop in earnings before we see a sustained stock market recovery.
The earnings season is all but finished in the US and this gives us a better indication of what lies ahead. Leaning on LGIM again, they stated that consensus forecasts are falling, and this is now unfolding into weaker corporate results.
Estimates for the next 12 months’ earnings were down 0.8% after the second quarter earnings season. After this earnings season, they have been cut by 2.5% and are still falling. Breaking this down further, since the start of October, forecasts are down by 5%. The point being, is that the rate at which earnings are expected to deteriorate, is accelerating.
How do earnings vary between sectors?
LGIM highlight that this still leaves room for slight positive growth in quarter four, but this outlook is roughly in line with their expectations earlier this year, in that earnings growth would grind to a halt by the end of 2022.
It’s also worth looking at the differentiation between sectors. Whilst those missing estimated third quarter results have been pretty broad based, although the tech sector got most of the headlines.
Looking at the revisions after results, there have been 12-15% downward revisions to quarter three estimates in Tech, Financials, Discretionary and Industrials. Only non-cyclical stock estimates remained roughly flat, and the energy sector outlook was increased significantly. Quarter four forecasts were trimmed in 71% of companies. Tech may have got most of the headlines, but it’s clear this is unfolding across all sectors.
(Non-cyclical stocks are companies from which people will continue to consume their products even during an economic downturn. These often include consumer staple goods, food, petrol, utilities and pharmaceuticals/healthcare.)
Is the inflection point just around the corner?
All the elements we have been highlighting are now starting to feed into consumer and business behaviours and many corporates are now feeling the pain. Whilst this is bad news, it does strongly suggest to us that we are nearing an inflection point when equities are likely to turn.
Of course, there are other factors at play which will influence sentiment to a greater and lesser extent, but corporate profitability is a main driver for equity markets.
As LGIM suggest, we are likely to see the Bond market be more resilient with inflation nearing its peak and we are evaluating a possible move back into bonds for our more cautious portfolios which will swallow up some of the cash currently held. A switch into equities with real conviction will have to wait a little longer.
Any Budget surprises?
Not really, as most of it is leaked ahead of the announcements nowadays, giving the markets plenty of time to digest the outlook.
Austerity is what the Truss government was desperately trying to avoid, but instead decided upon providing stimulus to an economy which was already overheating, certainly in inflation terms. Austerity is what we got yesterday as the Chancellor introduced measures which would help fill the coffers of the Treasury in a quest to reduce borrowing.
Whilst he introduced £55 billion of tax increases, some of the impact won’t be immediate and it is hoped that the economy will out of recession with inflation falling to below 2% by the time the tax increases fully unfold.
According to the Office for Budget Responsibility (OBR), it will take until the end of 2024 before national output returns to its pre-pandemic levels. This would mean that an entire parliament would oversee zero growth!
The OBR have stated that living standards will fall by 7% in total over two years.
In terms of positive news, grabbing the headlines was the inflationary increases in benefits and for the state pension, along with extra funding for the NHS and schools.
The clock is ticking and unsurprisingly, the thinking is that before the next election, the economy will have turned around, and Hunt will then deliver lots of treats to sweeten the electorate!
It’s encouraging to see both equity and bond markets rising strongly last week, and it reinforces the appetite for investing when the time is right. The excitement came on the back of better-than-expected inflation figures in the US but it’s important to appreciate that one month’s figures do not mean that next month’s data will follow suit. There’s room for disappointment!
Here in the UK, we have seen inflation rise to 11.1% prior to the Chancellors budget, which announced £55 billion in tax increases. The economy is going to struggle in 2023 and we are now seeing earnings deteriorate. Whilst this is bad news on the face of it, we have been watching earnings data in the US closely. Weaker earnings are one of the triggers to give us more confidence to invest our cash, certainly into equities.
At the moment, global equity markets are trying to interpret data in a quest to understand the immediate direction of travel. The path is unclear, but our feeling is that there may be some deterioration in prices before a catalyst occurs which leads to a sustained rally. Remember that an economic rally always lags a stock market rally!
Enjoy this autumnal weather. Beautiful colours!
Gary and the Blue Sky Investment team
Please Note: This communication should not be read as giving specific advice regarding your personal circumstances. This would only be given following detailed assessment of your individual needs. The value of investments may fall as well as rise; you may get back less than invested. Past performance is not necessarily a guide to future returns.