Global equities last week were once again little changed and remain at the top end of the trading range seen since last summer. This calm, however, has an uneasy feel about it because big question marks continue to hang over the economic outlook. We reviewed these areas of uncertainty a month ago and, a month on, it seems worth revisiting them to see if recent data has left us any the wiser.
First and foremost is the question of whether the US (and by implication, the West more generally) is heading into recession. This remains a matter of intense debate with leading indicators all very much still flashing red.
One such indicator is bank lending conditions which have continued to tighten as a result both of the Fed rate hikes and the regional banking crisis. While the latter looks unlikely to pose a systemic threat – even if it has claimed another scalp with First Republic Bank being gobbled up by JPMorgan – it does represent a significant drag on the economy.
Yet last Friday saw US employment post a larger than expected gain in April and the unemployment rate fall back to its January low of 3.4%. As for the first quarter GDP numbers released the previous week, the headline growth rate slowed to a sluggish annualised 1.1% but underlying demand posted a firm gain of over 3%.
In a nutshell, the lagging and coincident indicators of activity still show no sign of the imminent recession flagged by the leading indicators. We are sticking to our view that we are most likely headed into a recession but only a mild one.
Echoing in part this resilience, corporate earnings held up better than expected in the first quarter. S&P 500 earnings are now projected to be down only 1% on a year earlier, rather than the 5% forecast at the start of reporting. Importantly, the tech mega cap stocks, which have led the market recovery this year, generally beat expectations.
The second key question facing the markets is whether the Fed will ease policy later this year. As widely anticipated, the Fed last week raised rates by a further 0.25% to 5-5.25% and pointed to a pause in tightening. But it gave no indication that it was planning to ease policy later this year, as the market is confidently predicting.
We continue to think rates will remain higher for longer than the market believes. This is both because the economy is proving unexpectedly resilient and because underlying inflation continues to run at around 5.5%, with no clear sign yet that it is on a marked downward trend. Indeed, wage growth, which is a major focus for the Fed, has recently surprised on the upside.
The ECB also raised rates last week by 0.25% to 3.25% but categorically said it was not in ‘pause’ mode, and a further 0.5% increase looks on the cards over the summer. As for the BOE, it meets this Thursday. Following the recent poor inflation numbers, it also looks certain to raise rates by 0.25% to 4.5% with a further 0.25% increase looking fairly likely over coming months.
In addition to these two key questions, one new wild card is now rearing its head. The US needs to increase its federal debt ceiling and could run out of money as soon as early June according to Treasury Secretary Yellen. This in theory raises the all but unthinkable possibility of a US default. The issue is that the Republicans say they will only agree to raise the debt ceiling if there are sizeable cuts in government spending which are unacceptable to the Democrats.
We have seen this game of chicken played out on a few occasions before. Some extension has eventually always been reached, albeit often not until the eleventh hour and at the cost of varying degrees of disruption and market volatility. This time will most likely prove no different.
Beyond this tail risk, the main risk for equities is that they are having their cake and eating it. Valuations are back up to their long-term average in the case of global equities and significantly above in the case of the US. This is seemingly justified by the assumption of renewed gains in corporate earnings over the coming year along with a fall in interest rates.
The problem is that these two scenarios look incompatible. Interest rates will only be cut if there is a recession which would in turn undermine earnings. While a large slice or two of cake was more than justified this past weekend, cakeism carries rather more of a risk for markets.
That said, cakeism is much more of a problem for the US than elsewhere and Asia and Emerging markets equities look considerably more attractive because of their superior growth outlook and cheaper valuations. As for fixed income, even though markets may be overly optimistic on the speed of any US rate cuts, prospective returns still look better than for many years.
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