Investors may have thought that they had seen the worst of it, or at least knew what was coming, but fresh challenges have arisen for risk assets.
Some of these challenges admittedly are just iterations of longer-running issues. The latest US jobs data came in stronger than expected, which meant the US Federal Reserve now looks more likely to raise policy rates by 75bp at its next policy meeting in December. It also pushed off the expected date of the Fed’s ‘pivot’ to interest rate cuts. Strong US inflation data reinforced the market’s view.
In Europe, by contrast, it was weak consumer price data that confirmed the region’s slowdown due to the energy shock has gathered pace and that it is moving into (if not already is in) recession.
Budget concerns not unique to UK
The first new factor was market turmoil in the UK Gilts markets as investors questioned 1) the government’s ability to provide a fiscally sound budget outlook and 2) the willingness of the Bank of England to continue to act to prevent market interest rates from rising excessively. At the time of writing, 10-year Gilt yields had returned to their recent highs and sterling was weakening again.
Even though some believe the problems in the UK liability driven investing (LDI) market are specific to the country (in particular the leverage many funds employed), there has been spill-over into other markets (see Exhibit 1). This has put renewed pressure on real bond yields (and growth stocks) in particular.
The UK situation may not be as unique as investors might like, however. While the current situation there looks extreme, other countries are also increasing spending and their budget deficits. Germany recently proposed a EUR 200 billion package to offset the effects of high energy prices.
Such government action stymies central bank efforts to rein in inflation and could push them to raise policy rates even higher to offset the stimulus.
Oil production reduction ructions
The second new factor for markets was the decision by OPEC+ to reduce oil production, reversing the decline in Brent oil prices. They had fallen from USD 130 per barrel (bbl) to nearly USD 82 over the last three months, offering the prospect of some relief from inflation. However, they jumped to nearly USD 100 after the OPEC+ announcement.
Not surprisingly, investor sentiment remains negative, whether measured by put-call or bull-bear ratios. This environment could set the stage for a (short-term) rally. It may take just a few positive sparks. One of those sparks may be the upcoming US earnings reporting season.
At first blush, the prospects are not good. Earnings are expected to rise by just 2.2% from the third quarter of 2021. And even that figure is massively inflated by gains in the energy sector (see Exhibit 2). Excluding the sector, earnings are forecast to fall by 5.5%.
These figures, however, are “known” by the market and so should not drag it down. What will matter more are how earnings come in relative to market expectations and what guidance companies provide about the outlook. There are reasons to be optimistic on both fronts.
Brighter after all?
As seen in the recent data, US economic growth has remained solid. When growth is positive, company earnings tend to beat consensus estimates, although this is also often a function of companies ‘managing’ analyst expectations. As it happens, the consensus earnings per share estimate for the third quarter has fallen by 6% over the last several months.
The reports we get from companies also highlight that demand has been strong. Companies do complain more about their struggles to meet it.
Guidance is more difficult to forecast. On one hand, current growth is strong, but everyone is aware of the forecasts for recession. We would expect CEOs to be cautious about the outlook, but they are unlikely yet to downgrade estimates any more than average.
It is worth recalling that only 23% of companies typically raise their guidance during a quarter. In the second quarter, there were similar worries about recession and margin squeezes, but in the end the share of positive guidance was 35%. Despite the recent warning from US bellwether FedEx, earnings guidance overall is not any more negative than it was at this time last quarter and last year.
Negative sentiment and a positive catalyst could spark an equity rally, but we believe the medium-term outlook nonetheless remains difficult.
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