U.S. Equity Prices: Rout Over?

U.S. equity prices have stopped falling over the next last couple of days, but global growth headwinds will constrain the profit outlook. We retain our cautious bias.

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The recent drop in equity prices was sparked by weaker than expected growth in Europe, the steep decline in inflation expectations on the back of U.S. dollar strength, and the perception that policymakers are not doing enough collectively to support the global recovery. Negative global economic surprises amidst the downdraft in oil prices have undermined confidence in the sustainability of the global expansion, triggering a reset in the equity risk premium.

Typically, equity valuations and inflation expectations move hand in hand. But a gap opened at the onset of the latest QE program. Now that the latter is ending, valuations are recoupling with inflation expectations.

Eventually, lower oil prices should boost economic activity, but without more stimulative fiscal and monetary policy, growth outside of the U.S. will remain in doubt. In particular, evidence of some traction in euro area economic activity likely is needed to sustainably reverse the slide in inflation expectations, and by extension, fears of a profit slump.

On Europe, we continue to expect that results of the ECB’s stress tests at the end of the month, as well as easing in fiscal austerity, could brighten prospects – please see the next Insight, Euro Area: Potential For Upside Surprise?

(Part I) EM Credit Spreads: Unsustainable Divergence

EM sovereign and corporate credit markets have so far defied the selloff in EM equities and foreign exchange markets, but the odds of material spread widening are considerable.

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As G7 central banks have crowded out global fixed-income investors from G7 bond markets by depressing yields, investors have rotated into other segments of global fixed-income markets and bid up prices of hard-currency denominated EM sovereign and corporate bonds. Our EM strategists believe the stampede into EM credit markets has gone too far, and that these divergences between EM currencies and stocks on the one hand and EM credit markets on the other will not be sustainable.

Today, EM countries’ private sector foreign debt levels (as a share of GDP) are not lower than at the end of 1996 and early 1997, when the emerging Asian crisis commenced. This is not to argue that the EM world is headed for a similar crisis like what transpired in 1997-’98. The point is that currency depreciation raises foreign debt burdens and as such should lead to a re-pricing of credit risk – i.e., wider corporate spreads.

Although the EM public sectors’ foreign debt burden is very low, most developing nations’ fiscal positions will deteriorate going forward. This will occur because the growth slowdown will drive down corporate profits and consequently governments’ tax intake. In the meantime, political pressure to keep the population happy will lead many EM governments to loosen the fiscal purse. All in all, government debt and budget deficit dynamics will worsen, justifying higher spreads on sovereign credit.

Weaker EM growth and commodity prices also represent a menace to EM credit markets. Please see the next Insight, (Part II) EM Credit Spreads: Unsustainable Divergence.