Equity risks are rising: economic surprises turning lower

We are viewing with increasing concern the building evidence of disinflation in industrial commodity and energy markets. Economic surprise indices have turned sharply lower on a global basis, a move which cannot be fully explained by seasonal factors. In this context we were surprised by the relatively hawkish recent policy statements by the US Federal Reserve and Bank of England. For the US Fed, it was very much a case of one and not done at the recent FOMC meeting, where US rates were increased again. For now, earnings growth forecasts near 10% for each of the US, UK and continental Europe remain intact but we also detect ebbing momentum in this data compared to 6m ago.

Economic surprise indices are moving sharply lower and while some this may be seasonal, the rapid drop when combined with declining bond yields points to a genuine shortfall in activity versus earlier expectations.

Exhibit 1: Economic surprise indices moving sharply lower in recent weeks

In terms of earnings momentum, our equal-weighted 2017 earnings revisions indices for the UK and US have been falling in recent weeks. Earnings momentum is highly correlated to market performance over the short-term and in view of this data we believe price momentum for UK and US equities may slow over the summer months. In continental Europe, which has been the surprise outperformer for 2017 to date, over the last month our earnings revision index has fallen since the end of May. While it is clearly too early to tell if this is a new trend, it is consistent with the declining economic surprise index for the region.

Exhibit 2: Earnings revision indices falling in US, UK – and peak reached in continental Europe?

The declining momentum in economic activity has clearly been noted by global bond markets as yield curves have flattened significantly since Q1. Flat or inverted yield curves have clear slowdown or even recessionary implications. In this context, it was something of a surprise to us to see both the US Federal Reserve and the Bank of England publish relatively hawkish policy statements in recent weeks.

There is clearly a nervousness among investors with 2018 looming, which may represent the first year since 2010 when aggregate central bank balance sheets may be shrinking rather than growing. In this context, the US Fed made no concession to the more recent US economic data and in fact accelerated the debate on when to start tapering reinvestment of the proceeds of its maturing securities. We can understand the wish of the ECB to defer the discussion on what to do with its own QE program until later in the year, to avoid an involuntary tightening of monetary conditions, but the cost for investors is added uncertainty.

Based on the data we have to hand, we believe global markets are now set to trade sideways at best based on relatively high valuations, a tightening trajectory of US monetary policy and stable earnings forecasts. If the US Fed sticks to its current course, we may even see an uptick in volatility in Q3 until investors are able to form a view on profits expectations for 2018. There is in our view limited benefit in joining in the performance chasing at this point in the cycle. European equity ETF inflows may have reached record levels in recent weeks but in some respects the economic momentum appears to have peaked.