Posted 24 February 2023
This week has seen global stock markets give back a portion of the gains made in the first few days of February. Still, since the start of the year global stocks have made a total return of around 5% in £-sterling terms (Source: Bloomberg).
Over the past fortnight, market participants have come to accept inflation – and in its wake interest rates – will stay higher for longer than previously anticipated. As a result, rising bond yields have been one factor pushing equity markets lower. Still, this rise in yields has come about because of positive economic growth stories rather than stagflation fears. The monthly preliminary Purchasing Manager Index (PMI) data, which informs us about changes in business sentiment, this week pointed to surprising strength, especially within services. The service sector is most closely linked to consumption, and so it added to the positive indications from January’s strong employment and retail sales data.
The resilience of households is striking, but not really surprising, given the buoyancy of jobs markets across the western industrialised world. In the US, seasonally adjusted initial claims (the weekly count of people applying for unemployment insurance) remained below 200,000. A normal level (when the job offers and seekers are in balance) is around 300,000. A similar situation is being seen here in the UK and Europe. However, as we discussed last week, despite the tightness in labour markets there is a growing sense that inflation is not in any upward wage-price spiral.
Consumption is being underpinned by the solid jobs markets, but not by household borrowing, nor by reducing savings. Spending growth is solid and sustainable rather than booming, and therefore unlikely to be overly inflationary.
Meanwhile, the shortage of workers is causing many businesses to maintain or even increase capital expenditure. Notably, given the cost of capital is quite a bit higher than in recent years, companies are not funding these business investments out of expensive borrowing. Instead, they are funding the expenditure out of cost-cutting and retained profits (i.e., by cutting dividends).
To put it another way, to retain their competitive position, companies are facing a profit margin squeeze until their business investments begin to pay off, which may go on for some time. The upside to this story is that wage growth is unlikely to cause a price spiral because it is being offset by margin compression as companies are no longer able to pass on price rises without risking loss of market share. Inflation should hence remain contained, if not especially low. Once central banks, especially the US Federal Reserve (Fed), acknowledge the absence of a spiral, they can focus less on tight labour markets and so begin to ease interest rate pressure – even if that occurs later than anticipated at the beginning of the year.
For equity markets, such a scenario is not terrible news, but is not exactly good news either. Rising revenues but falling profit margins is a recipe for little or no growth in earnings. Moreover, since the scenario is one of overcoming supply-side issues, this is a medium-term rather than a short-term issue. And by retaining part of those earnings, the pay-out to investors through dividends and buybacks is likely to be weaker, at least until the cost of finance comes down. Nevertheless, stagnant to slightly falling earnings but increased business investment over a period are still much preferable to a severe earnings recession on the back of collapsing demand.
The announcements of dividend cuts by miners like BHP and Rio Tinto is typical of such cyclical companies. Chip maker Intel’s dividend cut was more shocking. Many will point to competitor NVIDIA’s standout performance to say that Intel’s woes are idiosyncratic, but we feel that such defensive behaviour is becoming normal across sectors.
While current absolute equity valuations are not stretched compared to more recent history, they are stretched in comparison to bond yields and longer-term history. While valuations are rarely a guide to short-term market performance, it is worth remembering that high valuations are equivalent to expecting good earnings and dividend growth. When companies disappoint, investors will be reluctant to hold those stocks and when new data releases challenge the narrative outlined above, markets are prone to short sharp sell-offs.
To this end, risk indicators have risen in the past week. For us, one of the key indicators is the US Dollar, still considered a safe haven asset. Therefore, global risk assets tend to fare better when the Dollar is in a bit of a decline, and that was the situation for November through to January.
As February has progressed, the Dollar has strengthened. The biggest driver of the moves appears to be China, with weakness in the Renminbi. The surprise caused by the end of the zero-tolerance policy to Covid cases generated a bounce in optimism, but a bounce in the economy seems to be taking longer than hoped. As we discussed last week, activity may start getting stronger when spring arrives, but we acknowledge that global metals and energy price falls are not a great sign.
In this state of suspension, however, more positive forces may return to the fore next week. We discuss structural changes to European and US natural gas price dynamics in a separate article below. The steep price falls are good news for Europe if they can be sustained, as currently higher than average gas storage reserves lead us to expect. One key aspect is that Russia is no longer able to squeeze gas prices in the same way, it has used up its power-play of withholding gas supply. Of course, that raises the prospect that Putin might feel the need to use other weapons. His “state of the nation” speech repeated threats of nuclear war much as he did last year. However, with fewer levers to pull, perhaps we should be more wary of these threats than before.
To summarise, it looks as though the big threat to market valuations of a deep and sustained recessionary period – as anticipated at the market lows of last autumn – has passed and given way to a more moderate outlook. This does not mean it is all plain sailing for investors to return to previous market highs, as large cohorts of US private investors appear to expect, if we read recent retail liquidity flows correctly. Instead, we expect the ‘tug-of-war’ between the different scenarios of this fairly unusual slowdown scenario to persist until spring is in full flow. As long as labour markets continue to be resilient, weakening global growth scenarios should only result in short-term volatility and/or a gradual grinding lower of markets as experienced in February so far. Meanwhile, improving risk indicators should lead to the resumption of a grinding higher of risk assets as seen in January. Patience will once again be of the essence for the long term investor, while for their investment managers, continued scrutiny in assessing and identifying the relative winners and losers from the gradually unfolding scenarios will be the order of the day.