While markets of late have been dominated by positive returns across all asset class, 3 factors drove Equities down in August:
- US corporate reporting season highlighted the deteriorating health of the underlying business, provided an earnings recession.
- Trade wars continue to run – the longer they do, the more lasting and permanent the drag on GDP and corporate growth
- The Fed underwhelmed with its recent rate cut – the market expected 50bp and got 25bp.
While central bank liquidity has provided a bullet proof backstop for over a decade now, fundamentals still count for something and August offered an insight into potential hurdles for the coming years.
All asset classes are in the black year to date – a welcome result after a less than positive year in 2018. August, however, was a bump in the road, and we saw a reversal of this almost straight-line appreciation. We have seen a flight to safety, with risk assets selling off while defensive assets such as Gilts offered protection.
US corporate profits signal recession
There can be a disconnect between economic prosperity and financial market performance, but the eventual link between the two is often tied to corporate profits. A strong economy feeds into healthy consumer demand, confident business investment and increased hiring, which means increased growth in earnings. Conversely, a reduction in earnings can be an early warning sign for pressures, both economically and financially.
That’s why it is important to pay attention to earnings reports, in particular from the US given its retained importance as a key driver of global economic health. At the time of writing, the majority of S&P 500 companies have reported results for Q219 and it is clear that earnings growth is weakening, down 0.4%. Short-term data is more than fallible, but when you factor in the Q119 fall in earnings growth of 0.2%, we have what could be described as an earnings recession. Non-financial corporate profits have been on a downward trajectory for some time now, as seen in the graph below.
Eventually investors will factor worsening corporate earnings into the price they are prepared to pay for the companies’ stock.
Trade wars run and run
Corporate earnings have struggled for a number of reasons, including the continued and escalating impact of trade wars. The impact of tariffs, both direct and indirect, is taking its toll. This has been compounded by the reduction in investment and hiring decisions by company management, and the need to find alternative supply chains.
It’s not just the US and China where the impact is being felt. Purchasing manager surveys suggest that manufacturing activity in August contracted in the eurozone, Japan and the US. This was only partly offset by improving services figures.
The tit for tat rhetoric means markets have been on a roller coaster for some time now. This month saw further escalation when Beijing announced it would apply additional tariffs of 5% and 10% on a further $75bn of US imports from September, in retaliation to the additional US tariffs in August. Trump’s response only exacerbated the situation and markets sold off sharply.
It is also important to understand the full impact of trade wars.
Trade confidence is being permanently dented, investment decisions delayed or cancelled, and alternative supply chains evolved; all at a cost to global growth. The chart below is a potential snap shot of the lasting impact this situation could create globally. Further evidence of the negative reach of the trade spat can be seen from data coming out of the EU, showing intra-eurozone trade contracting at the fastest pace since 2013.
Trade wars have a permanent impact on global economies.
Fed Rate Cut Boost?
But what about the Fed Rate cut – the first since the financial crisis – that took effect as we entered August? Surely this was a timely ‘mid-cycle’ boost to economic momentum?
Unfortunately, the market got ahead of itself after the change in tone from the Federal Reserve in December 2018. After ten years of living off cheap money and unwavering support from central banks, markets were expecting a 50bp cut from the Fed. They reacted badly to a mere 25bp.
The minutes released last month show a split amongst Fed officials. Some members favoured a 50bp cut given “stubbornly low inflation”; others angled for no change at all, arguing that the “real economy continued to be in a good place.”
Investors expect a rate cut at the next meeting, as risks of a global slowdown and trade wars headwinds continue. The Federal Reserve chairman has the unenviable task of weighing up increasing risks to economic growth with the inflationary risks associated with rate cuts, at a time of full employment and wage increases. With his committee so polarised, implementing a clear policy is more complicated, and the risk of policy error high.
In conclusion: Fundamentals overshadow monetary easing
August saw investors take off their monetary easing blinkers and think about economic and corporate fundamentals in a more balanced way. Trade wars are a clear and present threat to corporate prosperity, and signal a troubled path ahead.
The expectation of investors is that the central banks will continue to offer the support provided since the financial crisis, but beware: this support may be late in coming, or lack the teeth to satisfy investor nerves.
The above article was previously published by Parmenion on 5th September 2019