Stronger survey data quashes recession fears for now

Author: Alastair George

Equity market sentiment has performed a sharp U-turn in recent weeks. Above-consensus purchasing manager’s (PMI) data in China and the US has for now at least quashed earlier concerns of a US recession. We are encouraged by the recent improvement in the data, which is arriving a little ahead of our earlier expectations of around mid-2019. In addition, US/China trade talks appear to be making some further progress and may now be down to details, albeit important ones, even if the timing of any US/China Presidential summit remains uncertain. In the meantime and importantly for equity markets, consensus earnings estimates for 2019 now appear to have stabilised.

It seems that only a few days ago we were discussing the correlation between the inversion of the US yield curve and the likelihood of a US recession. We argued against the idea that the US yield curve was indicating an imminent US recession, as the inversion was driven by policy easing. A mini-crisis in market confidence as bond yields fell has since given way to a further move higher in global equities, led by China’s stock market which is now up over 30% year-to-date.

The quarter-long rally in global equities has in our view been driven by an unwind of risk premia relating to:

• Fear of overly tight US monetary policy
• Declining global GDP growth expectations for 2019
• Risk of a US recession in 2020;
• Fading prospects for 2019 earnings growth;]
  
• US China/trade negotiations
  
• Brexit.

By the end of 2018, the combination of these factors had pushed developed market equities to a 3-year low in valuation terms, a relatively attractive level in hindsight given the likelihood that the US Fed and ECB would indeed respond to evidence of a loss of economic momentum and loosen policy.

It would be easy to understate the scope of the shift in US Fed policy given its rapid implementation. It was only a few months ago that the US Fed was perceived to be monotonically raising interest rates and reducing the size of its balance sheet, with a predictable funding squeeze taking place not only in the US but also in emerging markets. Pleas from EM central bankers for the Fed to go on pause were largely ignored during 2018. Now, market-implied rates indicate that the peak in US interest rates may already have been reached in this cycle and Fed’s balance sheet reduction has been halted.

A lag between the change in global monetary policy, investor confidence and the real economy was expected. During Q119 this meant investors had to endure an uncomfortable but not illogical period of rising equities, poor incoming economic data and falling earnings estimates.
However, this period is now drawing to a close in our view. Survey data is starting to improve and hard economic data should also improve over coming months. We note for example that the Atlanta Fed’s GDP nowcast has been rising strongly during recent weeks and is now indicating US Q1 GDP growth of 2.3%, from only 0.3% as recently as the start of March.

Importantly for equity investors, earnings estimates also now appear to have stabilised on a global basis, following a 6m period of downgrades which was at its most severe in January 2019. We have observed in the past that equities are much more sensitive to the direction of travel of consensus estimates (which are themselves in many respects a proxy for corporate profits guidance), rather than the absolute level of growth. With profits forecasts now stable, the risk of a relapse in market valuations is much reduced, compared to earlier in the year.

Consensus forecasts now indicate 6-7% 2019 earnings growth for the US, Europe ex-UK and UK, having fallen from closer to 10% in October 2018. 2019 is therefore hardly a banner year for profits growth and the benefits of Trump’s US corporate tax cuts are now clearly behind us. However, this level of growth and profitability should be sufficient, given the currently easier outlook for monetary policy, to provide support for equities at current valuation levels.

Investors’ expectations for further short-term gains should however be tempered by the sheer extent of the global equity rally since December. While 2019 consensus forecasts have stopped falling, they are of course still lower than in October 2018, which has accentuated the rise in equity valuations as markets have gained.

Given the recent improvement in survey data in the US and China, we believe the incoming economic data is likely to be supportive of global equity markets at current levels. There is a distinction between support and progression however, and for this reason we maintain a neutral view on equities. Investors will now need to look to specific stock or sector calls to deliver outperformance. In addition to supporting the economy, easier credit conditions and lower market volatility should also be conducive to increased equity issue and M&A activity. For European markets, where the UK remains the largest single stock market accounting for 30% of market cap and also has the most active market for M&A, we would expect the current proposals for a meaningful delay to Brexit, if enacted, to facilitate increased corporate activity over coming quarters.