As markets fall, it is easy for a bull market in bearish analysis to develop. We are not unfamiliar with the bear case having consistently highlighted the overvaluation of developed market indices in recent years. The risk of a correction has been increasing since the US Fed in particular stepped back from policies which pushed global indices higher. Former Fed policymaker Richard Fisher’s comments on CNBC on how he was part of a group that “frontloaded a tremendous market rally” still have the ability to shock, even if not exactly groundbreaking news.
“It was the Fed, the Fed, the Fed, the European central bank, the Japanese central bank, and what are the Chinese doing? All quantitative easing driven by central bank activity. That’s not the way markets should be working. They should be working on their own animal spirits, but they were juiced up by the central banks, including the Federal Reserve…”
The extended period of unconventional monetary policy has of course enabled its effects to move beyond the financial market domain and into the real economy. Away from the headline narratives of China’s slowdown, investors are having to handle rapidly declining profits forecasts, Exhibits 1-3.
Market indices in each of the US, UK and continental Europe have closely tracked trends in EPS forecasts over the last 12 months. Extreme deflation in the commodity and energy sectors may be the obvious culprit but splitting out earnings momentum by sector we see few positives and many negatives elsewhere, Exhibits 4-6.
Exhibits 4-6: Sector earnings momentum
The start of 2016 has heralded some of the worst-ever January declines in market history. In some respects, markets have moved faster than we originally anticipated at the year-end, especially with respect to the flattening of the yield curve for example. It is therefore reasonable to question of whether it may be time to become more optimistic, but we think it is a still little early for any strategic shifts.
In our view, investors are having a reality check – valuations remain high outside the commodity/energy sectors while the US Fed remains for now on a tightening path. In emerging markets the outlook for China remains uncertain but more importantly global earnings expectations continue to fall.
We recognise that markets are unlikely to move from an extremely overvalued position to even fair value in a straight line and in this context today’s sharp bounce is no surprise. But in order to re-ignite a meaningful rally from current (still overvalued) levels
(1) EPS forecasts need to stop falling so sharply;
(2) Central banks need to be perceived to be standing ready to respond to declining economic momentum.
(3) Coordinated policy action may ultimately be required to stabilise emerging markets, first by easing upward pressure on the US dollar.
Until we see progress on these three points we believe global equity markets will remain volatile. In terms of EPS forecasts, our most recent calculations indicate that EPS forecasts continue to decline into 2016. For monetary policy investors currently fear a US monetary policy error as was seen in the 1936-37 period (which led to calamitous declines in market indices) even if this fear may ultimately prove misplaced. The emerging market question is closely related to the direction of US monetary policy. For the longer-term investor we would also highlight that index valuation multiples remain extended at present. We therefore maintain a cautious overall outlook for now, even if some of the more obvious downside risks are now off the table.