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?

Global De-Sync Continues

The divergence between U.S. and European data continues.

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The ZEW survey of German investor sentiment hit a major snag in October, sinking into negative territory for the first time in almost two years. Investor confidence has clearly been undermined by weak economic performance in the euro area. The results of the ECB’s bank stress tests, which will be released at the end of the month, could potentially remove one headwind that has been holding back risk-taking in the euro area. But it is unclear whether that will be enough to put a floor under sentiment.

Meanwhile, in the U.S., economic performance is stable. The NFIB survey showed that small business sentiment is holding up. The “good time to expand” index has hit a post-2007 high, although the employment-related components were slightly weaker. All told, there are few signs that problems outside of the U.S. are inhibiting economic growth domestically.

Our view is that global growth dynamics will support the dollar bulls. Sentiment is clearly stretched, but the de-synchronization of growth between the U.S. and elsewhere appears primed to last for at least a few more months. The latter should keep a solid floor under the dollar for now.

FOMC: Dots At A Turning Point?

The surge in the dollar has made clear that the U.S. economy will not be spared the deflationary pressures emanating from outside the country. The Minutes from the September FOMC meeting revealed that policymakers recognize the threat to growth, and the risk that additional dollar appreciation could drive inflation even further below the 2% target.

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The Minutes calmed fears that the FOMC might have a high pain threshold in terms of deviating from the current projected path for rate hikes beginning in 2015. Policymakers are clearly incorporating the dollar’s move and softening in global demand into their deliberations, and they may opt to maintain the “considerable time” language in the October statement.

The Minutes also highlighted that the FOMC places great importance on long-term inflation expectations, which were described as “stable” at the time. Since then, however, the 5-year CPI swap rate, five years forward, has dropped sharply and is close to levels observed around the time of QE2, operation twist and QE3. Policymakers are surely concerned. Some of the decline in inflation expectations reflects dollar strength and weaker commodity prices, but it could also reflect a loss of confidence in the Fed to deliver on its 2% inflation target in the long run.

The decline in long-term inflation expectations is alarming, although it would probably require one or two disappointing payroll reports for the FOMC to lower its projection for the policy rate (i.e. the median “dots”). Meanwhile, the 10-year Treasury yield has returned to the middle of its downward-sloping trend channel, after having tested the upper end of the range. The 2-year yield has fallen to the bottom of its upward-sloping channel. A breakout to the downside would require some combination of continued weak global economic data and softness in upcoming U.S. payroll reports.

Market Diverges From FOMC

The money market has largely ignored the steady upward march in the median dots over the past year. Among other possible reasons, our Global Fixed Income Strategy service points out that the divergence between market expectations and the Fed’s median dots this year reflects differing views on the terminal fed funds rate.

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The FOMC has only recently trimmed its estimate of the neutral rate by a quarter point to 3¾%, and the distribution around that estimate is fairly narrow (i.e. there is broad agreement on the FOMC). Meanwhile, the drop in the 5Y/5Y forward nominal Treasury rate implies that the market has revised down the terminal rate by about 100 basis points this year.

We side with the market on this call. The average real fed funds rate during successive business cycles has trended lower over the past 35 years. The rate averaged only 1% during the 2001-07 business cycle, a period in which potential growth was faster than it is today and demand was being buoyed by soaring home prices, rising debt, a falling dollar, strong EM growth, and fiscal stimulus in the form of the Bush tax cuts and increased military expenditure. If a 1% real rate was broadly consistent with full employment back then, it stands to reason that the neutral real rate is even lower today.

Testing the long side of the bond market might seem appropriate given our view on the terminal rate. Nonetheless, timing is critical. First, a low terminal rate has already been discounted, and market action in September suggests that the discounted terminal rate has bottomed for now. Second, market expectations can obviously shift around, and our model suggests that the U.S. labor market will continue to surprise on the upside for at least the remainder of the year.

(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.