Economic data continues to point in opposing directions, as do markets, with equities seeming to price in a recovery while bond markets a recession.
Recent Purchasing Managers’ Indices (PMIs) showed services sector activity accelerating in the US, with the index rising to its highest level in a year. The manufacturing series, however, dipped below 50, indicating contraction (Exhibit 1). Housing starts increased last month even as existing home sales fell. This split can similarly be seen in markets, with gains in equities this year alongside an inverted yield curve warning of recession.
Everything ultimately depends on inflation. How quickly will it slow towards central bank targets and what will it take to get it there? At least as far as the market’s expectation for inflation in the future is concerned, there seem to be no worries. Long-term (5 year-5 year) inflation expectations remain anchored at around 2.5% despite the turmoil in the world over the last 18 months, while one-year forecasts are near recent lows (Exhibit 2).
If this inflation forecast is realised with a “soft landing”, and the US Federal Reserve (Fed) cuts policy rates by 75-100bp by the end of this year as markets also expect, equities would likely continue to do well. In fact, following positive surprises from the first quarter earnings season, analysts have raised earnings estimates further. For the S&P 500, earnings per share (EPS) are forecast to rise by 5% this year and by 13% next year (ex energy).
However, there are reasons to be sceptical of the current equity market optimism, beyond the worries about the US debt ceiling.
First, forecasts of such steep cuts in policy rates may not be realistic unless they are accompanied by a sharper slowdown in growth (remember the yield curve; the Leading Economic Indicators index is also at a level which historically has corresponded with a recession in the months ahead). Otherwise, with the US unemployment rate at 3.4% and annual wages rising from 4.4% (average hourly earnings) to 6.1% (Atlanta Fed wage tracker), services inflation is unlikely to fall quickly enough.
Moreover, the strong performance of US equities this year has relied almost entirely on the technology sector (Exhibit 3), with more than half of the index return due to Apple, Microsoft and NVIDIA. If we exclude technology, the market has actually fallen by 2%.
The reasons for the outperformance of the technology sector has more to do with declines in policy rate expectations (boosting price-earnings ratios) and better-than-expected earnings than necessarily enthusiasm over Artificial Intelligence (AI). The pivotal question is whether such outperformance can continue.
We believe it is unlikely. Policy rate forecasts are more likely to rise than fall, and we would not anticipate another quarter where earnings beat expectations to the same degree. In fact, given the cumulative impact of the Fed’s hikes and slowing credit growth following the regional banking sector turmoil, S&P 500 earnings may instead disappoint.
The good returns for US technology stocks also explain part of the underperformance of emerging market (EM) equities versus developed market equities, despite expectations that China’s economic reopening would provide a long-needed boost (Exhibit 4).
The supports described above for US technology stocks have been lacking in emerging markets, particularly for China. Policy rate expectations have not declined, and the sector put up negative year-on-year earnings growth in the last quarter and disappointed expectations.
The difference in the economic trajectory, however, should eventually drive a divergence in the earnings growth trajectory, with China and the rest of emerging markets outpacing developed markets.
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