Economic Outlook for September
During August global equities showed a mixed performance with US equities and some Asian markets (Hong Kong in particular) advancing whilst Europe and Japan saw modest declines: the US S&P was unchanged (+0.05%), the NASDAQ had another positive month (+1.3%) but the Euro Stoxx 50 dropped by 1.6% and the Nikkei by 1.7%.
Investors could be forgiven for wondering why, with positive economic trends and favourable earnings reports, equity markets have been moving sideways (at best). One explanation can possibly be found in investors’ disregard of non-economic events up to July: market indices do not go up in a straight line and some profit taking on the back of escalating geo-political tensions is understandable at some stage. One can be encouraged though by the continued corroboration of synchronized, and moderately accelerating global growth trends. More clarity from the FED during its September meeting (regarding both interest rates and asset reduction) could be the catalyst for a catch-up of equities to the favourable economic backdrop.
Economies improving but equities stalling
Both backward-looking data (GDP growth being the most prominent statistic) and forward-looking indicators (PMIs for instance) keep generating positive surprises. The second quarter GDP growth estimate for the US economy, for example, was upgraded to a 3% annual rate from the original estimate of 2.6%. This was higher than expected and reflects robust consumer spending (underlying retail sales advanced by an annual 4% in July) as well as strengthening business capital outlays. This growth momentum is the highest since the first quarter of 2015 and is expected to be carried over into the third quarter in spite of some negative impact from hurricane Harvey.
Turning to forward-looking indicators, consumer behaviour remains a crucial driver for the US economy: the Bloomberg US Economy Consumer Expectations Index for August posted a strong increase (both month-on-month and year-on-year) to the highest level recorded since January. The forward-looking data for the Chinese economy are less straightforward and, like other China statistics, read with some skepticism by investors. Official statistics compete with private data providers and, together, leave it to investors to “paint the picture”. Fortunately, the recent barrage of lead indicators offer a consistent message of continued momentum, implying a low probability of a slow-down in the growth rate of the overall economy: the official manufacturing PMI for August was higher than forecast at 51.7 (values above 50 indicate expansion), whilst the official services PMI remained clearly above 50 (53.4 in August vs. 54.5 in July) in spite of the government’s efforts to reign in strong lending growth.
Against the favourable economic backdrop it is not surprising that the second quarter corporate earnings season led to more positive surprises compared to consensus forecast from analysts. According to FactSet - with more than 90% of the S&P 500 companies having reported - 73% of them saw realised earnings per share above estimates (the 5 year average of “earnings beats” is 68%) with aggregate earnings 6% higher than expected. The profit growth rate for S&P 500 companies has, as a result, accelerated into double-digit territory (10.2%) from 6.4% at the end of June.
A close relationship between profit growth and share prices is the cornerstone of equity investing, but in contrast to the first quarter earnings season, share prices have, on average, not reacted positively to positive second quarter announcements. The subdued equity performances during August can be attributed, to some extent, to non-economic influences affecting investor sentiment. There were indeed some causes for heightened uncertainty during the month such as the escalating North Korea crisis, doubts surrounding the ability of the US government to implement its economic agenda, some political uncertainties in Germany and Italy, and the Brexit process.
Central banks hesitate
One additional reason for uncertainty in financial markets was related to the annual gathering of central bankers and economists in Jackson Hole (Wyoming ,USA). Speeches by policy makers have in the past, provided clues to (sometimes major) changes in policies. Currently, market participants are wondering what shape the normalization of monetary policy in the US will take, and what the timing could be for preliminary discussions regarding the same subject at the ECB. In the end, no major policy clarifications were offered by either FED chair Yellen or ECB president Draghi. Yellen limited herself to support the regulatory framework introduced after the financial crisis. Draghi started his speech more encouragingly, stating: “The global recovery is firming up. In some countries like the United States, this process has been visible for some years, in others like Europe and Japan, the consolidation of the recovery is at an earlier stage. So it is fitting that our discussions are now focusing not only on how to stabilise the economy, but also on how to make it more dynamic – while at the same time improving people’s welfare.” The remainder of his address was limited to outline the benefits of global free trade. He did not mention the recent strength of the Euro exchange rate, which was associated with some further Euro strength following his speech, although recently ECB official have starting to voice their concern regarding the currency’s appreciation.
So, at the start of September, investors are still left wondering what to factor in with respect to US interest rates, a reduction of QE assets at the FED, and future normalization plans at the ECB. Central bankers themselves are starting to waiver somewhat as illustrated by the minutes of the FED’s policy-setting Federal Open Market Committee (held in July) when it summarizes the doubts that some FOMC members have regarding the economic theory applied for setting interest rates: “A number of participants noted that much of the analysis of inflation used in policymaking rested on a framework in which, for a given rate of expected inflation, the degree of upward pressures on prices and wages rose as aggregate demand for goods and services and employment of resources increased above long-run sustainable levels. A few participants cited evidence suggesting that this framework was not particularly useful in forecasting inflation. However, most participants thought that the framework remained valid, notwithstanding the recent absence of a pickup in inflation in the face of a tightening labor market and real GDP growth in excess of their estimates of its potential rate.”
In reaction to these FOMC minutes analysts now do not expect a rate rise during the September FOMC meeting but are hoping for a clarification of the FED’s asset reduction plan. Such an outcome would confirm a scenario of interest rates “lower for longer” which, combined with favourable underlying economic trends, could boost confidence of equity investors. In the long run, equities are highly correlated with economic fundamental trends (and corporate earnings) and, although duration of the current de-coupling is unpredictable, the positive outlook for equities has not changed.
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