Global equities have been rocked by investor fears of a global collapse and myriad structural problems. However, our long-held conviction in the US stock market remains strong.
There is a significant disconnect right now between leading indicators and the stock market. While the macroeconomic data are telling us the chances of a global recession are extremely slim, equity market valuations have this year implied a 50 per cent probability of a downturn. This is important because apart from the ‘Black Monday’ crash of 1987, there has never been a severe bear market in US equities without a recession.
That’s not to say that we haven’t seen significant falls, but these tend to be rare and losses are usually recouped within a year, because negative sentiment reverts to mean very quickly in the absence of a cyclical shock or recessions.
In periods of heightened uncertainty markets should reward those companies with more stable revenue streams by lowering the equity risk premium (ERP) used in their valuation. The market-implied ERP on the S&P 500 index came close to reaching global financial crisis levels in February.
Profit performance was poor in 2015, with index-level year-on-year numbers in negative territory. That said, when we strip out the oil and natural resource sectors, profit growth is positive. The dollar has clearly been a major culprit, but perhaps not as much as one might conclude from looking at the headline index.
The bulk of the poor performance was restricted to the first quarter of 2015 and a more gently rising dollar did not stop profit growth in a number of sectors in the second half of 2015. A regression of US profits against the dollar reveals only a weakly significant relationship and while companies are blaming the impact of the dollar anecdotally, it is possible that some have been conflating the affects of weak global demand.
The dollar remains our favoured currency, but Brexit-induced volatility could also entail sharp rallies in the exchange rate. Historically, the dollar has tended to weaken after the start of the US Federal Reserve’s tightening cycle, regardless of whether it is ahead or behind the global monetary policy cycle. This is a consequence of interest rate expectations adjusting well ahead of time. This time the committee judges that there is still considerable scope for interest rate expectations to adjust upward.
That said, as global growth improves, net outward portfolio flows could limit further upside. We think dollar strength will continue, but the pace of appreciation will be considerably lower than that of the past two years.
There are still risks in the world of course. China is grappling with an identity crisis at the same time as trying to steer its economy away from the edge; Europe is teetering under the strain of a refugee crisis as it struggles to fix its banking system and grow; and Japan has unleashed a drastic quantitative easing programme in its showdown with deflation. Meanwhile, global output expansion remains anaemic, leaving little room for policy error – monetarily or fiscally speaking.
Despite these problems and muted sentiment, we believe US companies are set to grind out steady growth over the next few years. Lacklustre oil prices lead some to believe that global demand will be much lower than expected, but we believe lower petrol prices will be a boon for western consumers. American consumer spending is usually particularly sensitive to this. We are not expecting phenomenal growth in the US anytime soon, but we think data show a recovery that should have a few more years to run.
Ultimately, global equity markets remain in the grip of fear, rather than responding to fundamentals.
Julian Chillingworth is chief investment officer at Rathbones