The equity market rally may be vulnerable to negative catalysts, due to increased expectations for rate cuts and QE
Forecasts for Q2:2019 US growth were revised down following below-than-expected economic data (personal income & spending, trade). The widely monitored Atlanta FED nowcast model points towards real GDP growth of 1.3% qoq annualized rate (2.5% yoy) in Q2:2019, down from 2% in mid-June and from actual growth of 3.1% (3.2% yoy) in Q1:2019. Moreover, business surveys (ISM) continue to demonstrate subdued prospects going forward.
On the other hand, US equity markets have reached an all-time high, recording gains of c. 9% since early June (19% YTD), mainly due to valuation expansion. The S&P500 12-month forward P/E has risen by 9% since early June to 17x (14x in January 2019) – the second highest ever excluding January 2018 due to: i) positive developments regarding trade (US-China trade détente part 2); and ii) heightened expectations that the Fed will proceed with rate cuts in order to keep the economy buoyant. Following the rally in June, equity positioning appears elevated (put/call ratio and short interest in cash equities are low relative to historical averages) and vulnerable to negative catalysts in the near term.
Indeed, the market is pricing in four rate cuts by the Fed in the next 18 months, thus any effort by the Fed to scale down these aggressive expectations may create some volatility. Attention will focus on Chair Powell’s Congressional testimony on Wednesday, especially following stronger-than-expected non-farm payrolls that increased by 224k, exceeding expectations by a wide margin and alleviating fears over a sharp slowdown in the labor market (see Economics Section).
At the same time, EPS growth consensus expectations for 2020/2019 remain at +11% yoy and have been broadly flat at an EPS level of $185 since early June. However, 2020 EPS forecasts have been cut by 4% since January. Moreover, since trade tensions resurfaced in early May, earnings revisions (# of upgrades vs # of downgrades) have been increasingly negative (see graph 1 page 3), suggesting high sensitivity to trade developments. While earnings downgrades are not devastating for equity markets, the temporary nature of the trade agreement, which could escalate further, may cap any improvement in earnings expectations. Attention will now turn to the Q2 earnings season, which kicks off on July 15th with Citi.
Switching from an expectation-driven to a relative return-driven framework, the outlook for equities appears more favourable, looking forward. The S&P500 Equity Risk Premium (ERP) has increased and remains elevated at 4.5% compared with a long-term average of 3.8%, suggesting that investors are faring better from equities than bonds (see graph below). Indeed, with circa 25% or $13 trillion of outstanding fixed income instruments carrying negative yields, investors prefer to maintain their interest in risk assets and/or add fresh positions (see graph below).
Core and periphery bond prices were boosted by the nomination of Christine Lagarde as ECB President, as well as by the European Commission’s decision to not continue the Excessive Deficit Procedure against Italy (the decision will be reviewed in the autumn) -- see Markets Section. The 10-Year Bund yield fell briefly below the ECB deposit rate, for the first time ever, closing at -0.399% (see graph 2 page 3).