The equity market correction

 Chief Economists View

After an unprecedented rally approaching a decade, the global equity market looks as though it may have finally run out of steam. Equity markets have had one of their most rocky starts to a year since the great bull market commenced in March 2009. From its high point in late January, the US equity market has shed over 7% (as measured by the US S&P 500). This compares to the only other years experiencing poor starts since 2009: 2016 (-10.5%), 2014 (-5.8%) and 2010 (-5.2%).

However, these other poor-start years experienced their declines with the first six weeks of the year. In each case, by the end of the March quarter, equity prices had recovered their losses and went on the post substantial gains over the year (+9.5% 2016, +11.4% 2014 and +12.8% 2010). Outside of the US, other major markets have experienced a similarly weak start to the year. Major European markets have fallen by around 7%, while major Asian markets are down by around 10%. Will equity markets put their poor start behind them, as happened in 2016, 2014 and 2010, or are we seeing the end of the great bull market?

The drivers of the recent poor equity market performance are well documented. They include: (i) a fear of rising inflation and interest rates; (ii) uncertainty over the global economic outlook due to the risk of a US/China trade war; and (iii) concern over tech stock valuations. How will markets play out over the remainder of 2018? We begin our assessment with the outlook for interest rates.

Leading into 2018, markets were anticipating a single 25 basis point (bp) rate increase by the US Federal Reserve (Fed). In contrast, at its December 2017 meeting, the Fed was signalling its intent to raise the fed funds rate three times over the course of 2018.The Fed duly delivered its first rate hike for 2018 at its March meeting and has continued to flag another two 25bp rate hikes over the remainder of the year. Market pricing has subsequently changed from the start of the year and has now fallen into line with the Fed’s forward guidance, anticipating a further two 25bp rate hikes before the end of the year. A combination of a re-rating of the outlook for both growth and inflation in the US economy has led markets to reassess their expectations on Fed monetary policy as the labour market continues to support a gradual rise in wage growth (and hence inflation) and as support from Republican/Trump tax cuts continues to support the growth outlook. The market re-rating of the prospects for Fed rate hikes has resulted in a lift in US interest rates across the yield curve, with US 10-year bond yields rising by around 40bps since the start of the year. Decomposing the rise in the US 10-year bond yield indicates that around ¼ of the rise was due to a re-rating of inflation expectations (i.e., 10-year break-even inflation rates are higher by 10bps), while the remainder of the increase is due to a rise in the real 10-year bond yield (which can be interpreted as a re-rating of the overall outlook for US economic growth). Considering the impact of higher interest rates on the discount factor applied to equities, we estimate that the rise in the real 10-year US bond yield could explain around ¾ of the fall in the S&P 500 since its high point earlier in the year.

While a market re-rating of interest rates will impact discount rates, the drivers of higher interest rates (i.e., growth and inflation) can also be expected to impact the outlook for corporate earnings. In fact, we have seen a significant lift in US company earnings expectations this year of around 7 percentage points, driven by the passage of the Republican/Trump corporate tax cuts in late December 2017.The positive impact on the S&P 500 of the rise in earnings expectations completely offsets the negative impact of the rise in interest rates. In our opinion, the fall in equity prices has largely been driven by the market’s repricing of risk. Notwithstanding periodic spikes, equity market risk has been in steady decline since the GFC. Over the course of 2017, equity market risk reached levels last seen during the period between 2004-2006, which has become known as the Great Moderation. The low-risk environment ended in early February, as the prospect of higher-than-expected inflation and higher interest rates emerged. Subsequently, fear of a global trade war erupting and concerns over technology stocks have resulted in the VIX measure of S&P 500 equity risk rising from a level of 10 over 2017 and January 2018 to establish a level of around 20 over recent weeks.

With the impact of the rise in interest rates on the S&P 500 being offset by the lift to the company earnings outlook, it has been the rise in the risk premium that has been the net driver of the fall in US and global equities from their early February high points. What does the rest of 2018 promise? In our view, markets have now repriced bond markets and equity risk to more appropriate levels. While we expect bond yields to rise gradually over the remainder of the year, our view is that current pricing of the US bond market is close to fair value. However, we find that US company earnings expectations remain elevated.

While we remain constructive on the outlook for the US and global economies, we find a level of 2018 corporate earnings growth of close to 20% to be optimistic. In our forecasts, we find the rise in wage growth begins to erode corporate profit margins and we anticipate earnings expectations to be disappointed by between 5% - 10%. Consequently, we see an ongoing mildly negative pressure emerging on the S&P 500 with a further 5% correction likely by year end.

Table 1: Financial market movements, 29 March – 5 April 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,662.8

0.8%

US

2.83%

9.3 bps

US Dollar Index (DXY)

90.46

0.3%

Nikkei 225

21,645.4

2.3%

Japan

0.05%

0.6 bps

USD-JPY

107.39

0.9%

FTSE 100

7,199.5

2.0%

UK

1.42%

6.8 bps

GBP-USD

1.400

-0.1%

DAX

12,305.2

1.7%

Germany

0.52%

2.7 bps

EUR-USD

1.224

-0.5%

S&P/ASX 200

5,788.8

0.5%

Australia

2.67%

6.4 bps

AUD-USD

0.768

0.1%


Source: Bloomberg



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