US equities tank

Chief Economist's View

The week has been dominated by the 6% fall in the US equity market. It has been difficult to pinpoint a precise reason for the equity sell off as there was little new economic or geopolitical information released over the week for the market to react to. As in February, technical trading in strategies linked to equity market volatility and price momentum appear to be at the heart of the sell off.

Market estimates show that the spike in trade volumes in the S&P 500 (associated with the price fall over the last two days) has been entirely driven by participants in these volatility-driven strategies. In addition, indicators of a broader, and hence more serious, decline in investor sentiment are largely absent. Credit spreads have been largely unaffected and currencies have been well behaved. In fact, the Australian dollar, normally punished severely when investor sentiment turns sour, has rallied over the week.

So, is the current market ruction simply a shake out of a few overleveraged equity strategies and, just like in February, we will see the market stabilise once the correction to these strategies has been completed? Or, is this the start of a bear market as the inherent overvaluation of US equities, puffed up by years of support from US Federal Reserve (Fed) monetary policy, is finally exposed? In last week’s brief, we argued that simple valuation metrics (such as P/E multiples) indicated that the US market was modestly overvalued by around 10%. Last week, we concentrated on the risk that rising interest rates posed to the equity market. We argued that increases in US interest rates in line with our forecast for the US 10-year sovereign bond yield being 3.5% by the end of next year, would be a sufficient catalyst to drive a mild correction in the US equity market, but not sufficient to cause a bear market.

Another catalyst for a sustained correction in the equity market would be a deterioration of the outlook for company earnings. Of course, the recent escalation in the US/China trade war presents a risk to the outlook for economic growth and, therefore, to the growth in company earnings. While this week saw no new announcements on the trade war front coming from the two belligerents, the market was reminded of the negative impact on economic growth by the International Monetary Fund (IMF) in its release of its World Economic Outlook (WEO) with the IMF modestly downgrading its global and US economic growth outlooks. Compared to its view in July, the IMF downgraded its global growth outlook by a modest 0.2 percentage points; from 3.9% for 2018 and 2019 to a still robust 3.7% in both years. Its outlook for the US economy remained intact over 2018 at 2.9% growth, but was downgraded for 2019 by 0.2 ppts to (a still above trend) 2.5%, “due to recently announced trade measures, including the tariffs imposed on $200 billion of US imports from China.”

However, notwithstanding risks from trade wars, European politics and emerging market debt, the IMF also notes that, “global growth for 2018–19 is projected to remain steady at its 2017 level.” How will the hit from the trade wars impact growth in company earnings? Unfortunately, the IMF does not report the expected impact on US company earnings from the trade wars. Based on our simulations of the US/China trade war, we expect the hit to global and US growth of the currently announced tariffs to be around the same at that reported by the IMF; i.e., a decline of 20 basis points in 2019. While we do not model the company earnings of the S&P 500, we do model overall US corporate profits.

Our results show a fall in corporate profits of around 1 ppt, relative to base, over the three years from 2019 to 2021, or about 0.33% per annum decline in profit growth. However, the composition of companies in the S&P 500 is weighted more heavily towards companies that are exposed to international trade than companies in the overall economy. Therefore, the hit to earnings growth of S&P 500 companies could be expected to be higher than for US companies on average. But even at triple the impact, the drag on S&P 500 earnings growth would still only by -1ppt per annum over the coming three years; an amount that would seem insufficient to cause a major re-rating of equities by investors.

Our view is that, in the absence of a deterioration in US economic fundamentals or a severe escalation of the trade war, equity markets will level out between now and the end of the year as the influence of the technical drivers of the recent sell off fade and as the outlook for the US economy remains robust.

Table 1: Financial market movements, 4 - 11 October 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,728.4

-6.0%

US

3.15%

-3.7 bps

US Dollar Index (DXY)

95.02

-0.8%

Nikkei 225

22,590.9

-5.8%

Japan

0.15%

-1.3 bps

USD-JPY

112.16

-1.5%

FTSE 100

7,006.9

-5.5%

UK

1.67%

0.5 bps

GBP-USD

1.323

1.6%

DAX

11,539.4

-5.8%

Germany

0.52%

-1.3 bps

EUR-USD

1.159

0.7%

S&P/ASX 200

5,883.8

-4.7%

Australia

2.73%

2.3 bps

AUD-USD

0.712

0.7%

Source: Bloomberg

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