Markets sour on news of resilient economy
Posted 7 July 2023
Last week we commented how the second quarter’s positive stock market returns were driven by a somewhat surprising improvement in investor sentiment. It’s surprising for several reasons. At the end of March fear was uppermost that the crisis facing US regional banks would lead to a serious deterioration in lending conditions and a more pronounced slowdown than previously anticipated. Surprising also because while bond yields rose, analyst forecasts of corporate profits did not change much beyond anticipating a period of stagnant growth.
But over the past week markets look to have abandoned this narrative. Positive US job growth figures have been blamed for a reversal in sentiment, with equity and bond markets have fallen and bond yields have risen. So why have investors shifted their views so suddenly to the downside, even though bond yields have not risen in any meaningful way when compared to the period between March and the end of June?
To make some sense of the latest markets drama, let’s remind ourselves of what are the principal factors determining valuations and their direction of travel. The primary driver of stock markets over the medium to long-term is the anticipated change in the profitability of stock market quoted businesses in aggregate. Improved corporate earnings, or just the prospect of better figures can provide equity markets with momentum. A deterioration in earnings does the opposite. In the absence of other more immediate drivers which we will discuss further down, the sequence of the different stages of the economic cycle usually determines the direction of travel of corporate earnings.
Secondarily, the overall level of valuations is driven by bond yields, which most simply put can be seen as the competition to equities, i.e. the higher they are, the higher the equity yield as a function of corporate earnings has to be to justify the same stock market level.
An interlinked element is central bank policy, which sets both, levels of liquidity and interest rates. Central bank, or monetary policy shifts play a large role in whether the economy’s contraction or expansion might be offset.
Such policy moves affect not just how much profit businesses can generate, they can also determine the length of an economic cycle. A short downswing means businesses can survive; a longer one can mean the opposite. The central bank ultimately determines whether the cost of capital and borrowing is high or low and therefore drives changes in business and consumer demand.
At times it is not just the stage of the economic cycle and cost of money that determines the direction of the economy, but also government spending (fiscal policy) and/or external shocks like the COVID-19 pandemic. That’s in part because governments can usually borrow when lenders are reluctant to loan money to businesses. Furthermore, cost of capital headwinds can be dealt with in a way that has little impact on earnings when growth is on a firmer footing. Last but not least there is the issue of general monetary liquidity. If there is more money circulating in the economy than is strictly speaking required, then the extent of the market reaction can be much less pronounced then when liquidity is tight.
Where all these factors combine to determine capital market valuations, investor sentiment is the proverbial glue that brings all factors together to determine whether there is a positive or negative interpretation of the prevailing circumstances and how heavily the one or other of the four will impact market direction.
The change we experienced over this week was one of sentiment towards the future cost of capital. Up until the end of June there was a growing expectation that at least the US central bank, the Federal Reserve, had, or was close to reaching the peak of their rate hiking cycle and that cost of capital as a result would not rise further and indeed was likely to start to fall over the coming 6-12 months.
Particularly hawkish statements from the Fed chair J. Powell last week at the SINTRA meeting in Portugal of central bankers began to challenge these expectations. This week’s data flow of continued tightness of the US labour markets which has been driving the second round effects on inflation (wage-price spiral concerns) provided more evidence that the Fed may well not be done with raising rates and keeping the cost of money at current elevated levels for longer than had been anticipated. This in turn would mean that the other central banks who were expected to be following the Fed in due course, would now be even later.
So, in summary not particularly much has changed on the hard data front over the past days, but on the contrary, a surprisingly strong US labour market report disturbed the fragile market balance we have written so often about over the past months. Whether this return of ‘good economic news is bad news for market valuations’ is enough to sour sentiment more permanently, remains to be seen. A second set of labour market data on Friday presented much less of an upward outlier, however confirmed that the US labour market remains just as tight as it was last month, with no signs of imminent turning.
As we described above, higher cost of capital can more easily be absorbed and carried by the economy when accompanied by decent growth and good levels of monetary liquidity. Both of these conditions remain broadly in place at the moment, which tells us that markets should continue to carry a higher probability of trading sideways then down over the summer. However, if the other effect of this economic resilience is a slowing or reversal of the recent steady decline in inflationary pressure from the input cost side (more on this in our dedicated article about global inflation this week), then the central banks may see themselves forced not only to raise rates ever higher. They may indeed, perhaps also have to more drastically drain liquidity from capital markets by stepping up their monthly QT (quantitative tightening) program of selling bonds against market liquidity from their still very extended balance sheets.
For the time being positive sentiment may well prevail, but for market stability to remain that way, market participants will paradoxically be wishing for a continuation of the other side of this week’s data flow which presented an environment, where services gradually start to follow the manufacturing sector into an economic soft patch.