Six charts that explain the current stock market environment

Having just passed the halfway point of the year what can we expect from markets now?

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  1. Charles Stanley

The first half of 2019 has been characterised by some of the strongest and most broad-based returns seen since 2009. US equities have led the way. Most asset classes have returned more than their long-term annual average in just six months, although that is not a reliable guide to what might happen going forward.

This chart shows price returns only and does not include dividends

However, economic growth (as measured by GDP) is pretty sluggish – certainly outside the US. Ongoing tensions over trade talks between the US and China could continue to hamper growth, although the threat of 25% tariffs on an additional $300bn of US imports from China is currently off the table.

Despite this companies are still faring pretty well for the time being with growth in their earnings robust.

Global inflation remains very low and there has been a marked shift in central bank guidance within the developed world. The US Federal Reserve confirmed at its June monetary policy meeting that it is prepared to cut short-term interest rates to support the US economy.

It was only seven months ago that the Fed seemed set on a path to raise interest rates even further so the 1% or more rate cuts anticipated by the market over the next 18 months is a huge turnaround in expectations of the future interest rate landscape.

As interest rate expectations have fallen so have the yields on government bonds – the so-called ‘risk free rate’.

Why is this important for equity markets? Well, the more expensive bonds become, and the lower their yield, the cheaper equities appear in comparison.

At the moment there is a very generous global equity dividend yield over global investment grade bond yields and a near record yield differential between FTSE 100 equity index and ten-year UK government bonds.

Lower sovereign bond yields also have the effect of lowering the so-called ‘discount rate’ that is applied to future equity earnings. This boosts equity valuations by raising the earnings multiple the market is prepared to pay.

With bond yields so low (and prices high) shares look reasonable value. Earnings are still growing and the ratio between price and earnings (the PE ratio) is looks ok versus history. In aggregate shares are not expensive, though neither are they that cheap.

So where do we go from here? It seems to us that much of prospect for interest rate cuts is linked to the downside risk to growth that an ongoing stalemate on trade is likely to cause. In short, a trade deal and 1%+ rate cuts in tandem may be too optimistic and markets could be disappointed on either front.

It feels a little like 2014-16. During this period, equities posted reasonable returns, but caution on the economic cycle and declining bond yields made investors increasingly favour defensive equities (for a relatively generous and sustainable dividend yield) and growth stocks (for more consistent earnings growth) at the expense of the value style, which is generally more exposed to the economic cycle.

Against the background of sluggish economic and corporate earnings growth and higher starting valuations, it is reasonable to expect more moderate returns in the months ahead. Notwithstanding some near term vulnerability in share markets, we still maintain a long-term preference for these over bonds on the basis of relative valuation.

Past performance is not a reliable guide to future returns. This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus. If you are unsure of the suitability of your investment please seek professional advice.

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