Where next for stock markets?

WORLD markets marked the end of summer in a generally disgruntled mood this past week. Central banks in the US and UK fueled recession fears with further interest rate rises of 0.75% and 0.5% respectively. While the hikes were no more severe than expected, markets added to their declines for the month, even in the hitherto defensive UK.

What rattled investors most was the US central banks insistence it will continue to raise rates as necessary to return inflation to low levels. That poured cold water on the notion the US economy could be headed for a soft landing where growth merely slows under the pressure of rising rates but doesnt move into reverse.

The US Federal Reserve indicated interest rates will increase by another 1.25% by the end of this year, to around 4.4%, and that rate cuts shouldnt be expected until 2024¹. That flies in the face of earlier hopes that rates might start to fall in 2023.

Meanwhile, the oil price dipped below $90 per barrel despite concerns of an escalating war in Ukraine and expectations China will successfully engineer an economic growth recovery over the next few months². The question of whether or not the US economy can skirt a recession remains key.

Closer to home, the Bank of England accompanied its latest rate rise with a statement indicating it believes the UK economy may already be in a recession, albeit a very shallow one for now. A reduction in the Banks expectation for October inflation from 13% to 11% owing to the Truss governments intervention to limit household fuel bills was a lone piece of moderately positive news³.

Fridays mini-budget underscored the new governments priority of countering rising inflation and interest rates with increased spending and tax cutting measures designed to boost growth. Working on the assumption based on history that lower taxes tend to increase the governments tax take rather than reduce it, the policy could work and prove sustainable. For now though, the currency markets seem unimpressed, with concerns about the cost of these latest measures further weighing on the pound.

Developments to look out for as we head into the final three months of the year include the corporate earnings season which starts next month, retail sales data particularly in light of the 1.6% drop in sales recorded in the UK last month but further signs of resilience in the US and any signs of peaking inflation⁴.

The corporate results season will be of particular interest to investors. As well as providing a precise reading of earnings growth, it will encompass information about how well companies are standing up to the combined pressures of rising input costs and increasingly cautious consumers.

The landscape may be challenging, but if companies are adapting successfully to it, a vital pillar of the stock market will remain intact. Current estimates suggest US corporate earnings are on course to grow by 9% this year in aggregate, although stripping out the energy sector, growth is expected to be in low single digits⁵.

Meanwhile, retail sales will remain the acid test of consumption behaviours. Domestic consumers account for more than two thirds of the US and UK economies, and an ever increasing share of the economies of important emerging markets, ranging from China and India to Brazil and South Africa.

Countries like these have a significant impact on world growth and are increasingly important destinations for Britains exports.

Valuations will be a further factor to follow. In the US, which now accounts for over two thirds of the worlds stock markets by size, valuations have fallen back this year from relatively elevated levels.

Based on the earnings companies are expected to achieve over the next 12 months, the S&P 500 Index trades on around 16 times earnings compared with an average over the past five years of 19 times⁶. While this number could still fall further should investor sentiment weaken again, the froth of 2021 appears to be well and truly gone.

Opinions as to where stock markets are headed next are widely split, but the general consensus seems bearish. In an important sense, this should provide some comfort. Markets tend to be at their most perilous when confidence is at a peak and there is little scope for investors to add to their positions.

An important countertrend investor emerged just over a week ago in the shape of the celebrated technology investor Cathie Wood of Ark Invest, who reportedly added to her positions across a range of stocks in the expectation that US interest rate hikes will eventually lead to a period of deflation⁷.

As ever though, maintaining a diverse portfolio of investments remains an efficient way to navigate difficult markets. China and Japan are two prime examples of markets out of step with the US, Europe and the UK in terms of interest rates and inflation.

In both countries, inflation is low and interest rates are either very low (-0.1% in Japan) or low and falling (China). Weak currencies in both cases also put these countries in a strong position to capitalize on international demand as supply chains recover.

Meanwhile, some government bonds are beginning to look more interesting, as expectations of further interest rate rises and yet slower growth deepen. Five-year US Treasuries now yield around 3.9%, which could be enough to attract investors who believe the Fed will successfully peg back inflation to low levels over the next couple of years⁸.

So, given the current uncertain outlook, there remains a strong case for keeping a broad exposure to investments in different countries and across asset classes, for example, bonds, commodities, gold and commercial property. Shares may beat all of these over the short to medium term, especially after such a disappointing first half to the year. But there again, they may not. For most investors in the current climate, relying on shares alone may be too much of a risk to take.

source:

¹ Federal Reserve Bank, 21.09.22
² Bloomberg, 23.09.22
³ Bank of England, 22.09.22
⁴ US, 16.09.22
⁵ FactSet, 16.09.22
⁶ FactSet, 16.09.22
⁷ Bloomberg, 14.09.22
⁸ Bloomberg, 23.09.22