Slower growth could squeeze equity rally
Equity markets are caught between slowing growth and tapering central bank stimulus, says Morningstar head of equity research Peter Warnes.
Amid a record earnings season, economic warning signs are flashing, sparking concerns that flagging economic growth could cut short the equity rally just as central banks prepare to trim stimulus.
In a warning signal for the post-pandemic boom, US consumer sentiment and retail sales fell in July while cases of the more infectious Delta-variant rose. In China, an unexpectedly sharp decrease in industrial output, investment and retail activity added to concerns, sending the Shanghai exchange down. A commodity rout has seen iron ore prices tumble 27% in the last month as China clamps down on steel making.
Equity markets followed suit this week. The ASX 200 is down 2% in its longest losing streak since October. European stocks had their biggest fall in a month Thursday, with London’s FTSE and Europe’s STOXX 600 down 1.5%. In the US, the value rally has stalled, with energy down 5% since June.
Investors are also grappling with the prospect that the extraordinary stimulus from central banks around the world may begin to taper, says Stephen Miller, an advisor at GSFM funds management.
“It’s put central banks in an awkward position given they were considering withdrawing support,” he says.
“We’re got central banks thinking of withdrawing stimulus and the peak of global growth has passed us, so we’ve had this reaction in global risk markets.”
In its August meeting, the Reserve Bank of Australia (RBA) stuck with plans to begin reducing the size of its bond buying program from September. Minutes from the US Federal Reserve’s July meeting, released on Wednesday, suggested it could start tapering this year.
The prospect of tapering stimulus and slowing economic growth puts equity markets between a rock and a hard place, says Morningstar head of equity research Peter Warnes.
Even if central banks backtrack stimulus reduction, markets will be reckoning with the end of the post-pandemic boom and slowing growth, he says. If the economy proves resilient, markets will have to deal with the end of central bank stimulus, first the end of bond buying and eventually, higher rates.
“It’s a question of which devil do I take? Either option will have an impact because valuations can’t be supported,” he says.
“If the rest of the world is normalising, why won’t financial markets? And normality is a P/E ratio 30% lower than now.”
From inflation fears to slowing economic growth
Concerns about slowing economic growth come after months of market preoccupation with higher inflation. A cocktail of government stimulus, consumer spending and supply bottlenecks stoked fears that rising inflation would force central banks to rapidly hike rates and slam the brakes on equity markets.
Higher interest rates increase borrowing costs and reduce the present value of future earnings, hurting companies reliant on future growth.
Warnes and Miller agree that a slowdown in growth was always likely because the V shaped recovery that drove double digit earnings was unsustainable.
The tapering of growth has been exacerbated by outbreaks of the Delta variant around the world. Daily cases in the US have tripled to 152,000 in the last month while China has shut one of the world’s largest ports over an outbreak.
In Australia, Sydney is approaching its 2nd month in lockdown and Delta is a “huge problem” that’s likely to weaken economic growth and raise unemployment, says Peter Tulip, chief economist at the Centre for Independent Studies.
Meanwhile bond markets signal relative calm over inflation. Yields on US 10-year Treasury notes have fallen nearly 30% from March highs as investors continue to vacuum up safe government bonds.
“Markets have got something further to worry about and that’s pushed inflation into the background,” says Miller.
New data has also bolstered the arguments of central banks claiming that inflation would be ‘transitory’, with prices for used cars, motor insurance and airfares normalising after double-digit spikes.
The pace of US inflation steadied at an elevated level in July, rising 0.5% on a month-to-month basis versus 0.9% in June. It was up 5.4% from July one year ago, the same rate as June.
The breakeven inflation rate, a common metric for measuring future inflation, stabilised around 2.5% in the US, only slightly above the central bank’s target for an average of 2%.
For investors looking for clarity in the daily barrage of economic data, Warnes recommends keeping an eye on consumers, whose pending makes up 65% of the economy.
“Get rid of the household and the economy goes nowhere,” he says, “Keep an eye on what’s happening with retail sales and wages growth.”
He advises caution, saying it’s easy to confuse a sensible risk appetite with bearishness.
“People say to me Warnesy, you’re a bear. But I’m not. When I see the market’s in the right frame of mind I’ll be the biggest bull.
"This has just gotten away from us.”