After new US all-time highs, what now for markets?

After markets got off to a fabulous start in 2019, Garry White looks at what could be next for equities.

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  1. Garry White

Equity markets have recovered from the brutal sell-off in the final quarter of 2018, as the S&P 500 and the DJIA both hit new record highs this week. The charge forward followed some forecast-beating earnings reports, which is important as expectations for corporate profit growth in 2019 have plunged in recent months. So, with a number of potential challenges ahead, what lies in store for markets now? Is it a case of sell in May, as the old stock market adage goes?

The dark days of December were characterised by steep falls in equities, as market participants became increasingly worried that the US Federal Reserve was making a policy error by tightening into an economic slowdown. Thankfully, this has now been reversed. Following significant pressure from President Trump, the US central bank moved to such an accommodating stance that another interest rate increase in this cycle is now pretty unlikely. Rate rises are bad for equities because they make bonds more attractive in terms of yield, but also increase borrowing costs for companies, reduce loan demand and dampen investment, which has an impact on the wider economy.

This dovish backdrop has been the main driver of gains so far this year. Economic data has been, at best, mixed – and expectations for corporate profit growth have come down substantially. For the full-year, earnings growth expectations in the US now have dropped to a relatively pedestrian 4pc to 5pc. In September, Citigroup was forecasting 2019 growth of 12% – around three times current market expectations. It is therefore a major positive that the new highs this week were sparked by positive earnings reports.

With global economic data so mixed, a resolution to the trade war is imperative for sentiment. The big risk here is that the much-promised deal under-delivers.  A good deal for equity markets would be one that removed all of the tariffs imposed so far as part of the dispute and brought some of the high pre-existing Chinese tariffs down. It would need to have convincing changes on intellectual property, and confirm the idea that a US company investing in China need to no longer have a Chinese partner. It would include contracts or bankable future orders for more US goods like soya beans and energy than China is currently buying.

It is arguable that a successful resolution has already been priced in, as there is obviously serious engagement at a senior level on both sides. A failure on this front will be a negative for stock markets. However, equity-market performance is an indicator that President Trump watches very closely and he is already laying the groundwork for his 2020 re-election campaign. Continuing trade belligerence with China will not help him on this front – a fact he probably understands all too well.

There are a number of other risks ahead too. Donald Trump has threatened to extend his trade spat to Europe. Indeed, just this week the president pledged to retaliate against “unfair” EU tariffs that Harley Davidson partially blamed for its nearly 27% drop in first-quarter profit. President Trump argued that EU tariffs had forced Harley to move US jobs overseas to escape tariffs imposed by Europe following duties the White House placed on imported steel and aluminium. It meant tariffs on Harleys climbed from 6% to 31%, and they are set to rise further in 2021. “So unfair to US. We will Reciprocate!” the president tweeted.

The biggest casualty should Trump turn his attention to the EU is the auto industry, which is already suffering structural problems. Some countries have been tightening requirements for car loans and there are consumer concerns about which technology to buy following the diesel-emissions scandal. Tariffs on this sector will be very damaging.

The oil price is also rising again after Washington refused to extend its waivers for Iranian oil, a move that will tighten the market. Saudi Arabia’s Energy Minister Khalid al-Falih said last week that the Kingdom’s crude production would remain within levels outlined in Opec-led output cuts but the top oil exporter would also be responsive to its customers’ needs. This implied that Opec is in no rush to make up for the lost output from Iran. Fresh violence in Libya could also deliver a major shock to oil markets.

However, the most likely scenario is for markets to “muddle through”. As this year progresses, we are likely to see evidence of better economic growth, reflecting more dovish central bank guidance and reduced trade tensions between the US and China, and we would also expect some pickup in the market expectations of corporate profit growth. However, the second quarter is unlikely to see a repeat of the outsized returns we have seen for the first quarter, so banking some gains could be a prudent move.  

It is clear that corporate earnings growth this year will be considerably lower than in 2019, and the one-off effects of the big tax giveaway in the US are now discounted by the market. So, from these levels it is more likely returns will be modest, and we may well have seen the bulk of the gains for the year in the first few months. However, this does not imply that the tone will turn bearish, but equities are likely to pause for breath until evidence of better economic growth emerges later this year.

A version of this article appeared in Friday’s Daily Telegraph.

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