Strategy: Markets shift – and discount – perceptions

18 Feb 2016

  • US growth and improving consumption; Eurozone growth stable on the surface
  • Japanese GDP shrinkage puts ‘Abenomics’ into question
  • Trade data from emerging economies: weak; surge in Chinese credit may not be positive
  • Equity markets: earnings outlook is murky

Last week, we asked whether the US was on its way to recession and concluded that it looked unlikely. Data this week continued to be mixed, but higher retail sales point to an improvement. However, the latest earnings reports have not been supportive of equities. The number of companies that surprised with better-than-expected earnings and sales in the US and Europe has not been inspiring so far and on an annual basis, reported earnings per share are on a downward trend in the US, Europe and emerging markets (see chart). That said, we believe any downward risks have been discounted amply in developed equity markets.


A single data point does not change a trend, but the latest US retail sales report struck a positive chord (see chart). Headline growth was held back by lower petrol sales. Core data used to calculate GDP showed a more encouraging gain. Inflation was most likely modest, if not negative, so this increase points to an improvement in consumption. In addition to recent upbeat data on wages, there is good news on household balance sheets: they benefited from appreciating financial assets and house prices and energy-related windfalls.

Initial jobless claims saw a meaningful decline after several weeks of gains. The level of claims continues to point to labour market strength, which should benefit consumption.

Not all data was positive. Consumer confidence fell in early February (see chart), the Empire manufacturing index remained deeply in negative territory and sentiment among homebuilders slipped. Sentiment may have been dented by the turmoil in financial markets, but more significantly, mortgage rates have not increased, limiting the effects of tightening financial conditions.


Eurozone GDP growth stabilised (see chart), which was positive for two reasons. One, the slowdown in growth has come to a halt. Two, while leading indicators had pointed to stronger growth, some real indicators such as industrial production and retail sales had not. Thus, stable growth was more than some had expected.

At a country level, the data shows that growth is still patchy. The German economy is now 5.5% bigger than it was at the peak before the financial crisis, but the French economy has grown by only 2.7%. The Greek economy, still mired in depression, has shrunk by over a quarter.

Even with strong growth recently, Spain is 4.6% below the peak. At 4.8% of GDP in 2015, the government is struggling to lower the fiscal deficit. The European Commission expects it to stay above the 3% threshold this year. The economy is still 8.9% below the pre-crisis peak in Italy, where the banking sector is suffering from a high level of non-performing loans.

So while growth looks okay on the surface, there are significant risks. Markets have doubts about the impact of unorthodox monetary policy, but hints at fresh measures should mean that the ECB has boxed itself in to deliver in March. A further cut in the (already negative) deposit rate looks likely in our view, as do changes in the asset purchase programme.


Japanese GDP contracted in the fourth quarter by more than expected, mainly due to the sharp fall in household consumption. Business investment has improved in recent quarters, but weak machine and machine tools orders have raised doubts over the sustainability of this improvement. The efficacy of the pro-growth, pro-inflation ‘Abenomics’ policy is really in question now. Unemployment is low, but wages and household income are not growing. Core inflation appears to have stalled far below the Bank of Japan’s 2% target.

Trade data from early reporting emerging economies was weak on balance (see chart). Most data is reported in US dollars, but even in local currencies, exports fell. So this weakness is more than just a temporary soft patch. Some countries have lost competitiveness and most are suffering from the growth slowdown in China and modest growth in the US, Europe and Japan.


Bank credit and broader total social financing, which includes bond and equity issuance, surged, but this may not be only good news. Firstly, the surge was so strong that we could see payback in the coming months. Secondly, the People’s Bank of China had provided plenty of liquidity ahead of the Chinese New Year. Thirdly, strong credit growth is out of sync with other – tentatively stable – indicators. Finally, strong credit growth could lead to viable investment projects, but it only exacerbates China’s rapidly worsening debt problem.


Recently, we have seen a significant shift towards market scepticism of monetary policy. Since the Bank of Japan said ‘no’ to negative interest rates and then implemented them, the yen has gained 5.8% on the US dollar and the Topix equity index has dropped by 10.5%. The ECB eased policy in early December and has hinted at more easing in March, but the euro has risen by 5.0% and the STOXX 50 has lost 14%. In the US, market expectations of policy tightening have been pushed further into the future, but this has not kept the S&P500 from falling by 9%.

Will the markets now return to the fundamentals and let good data be good for them and bad data be bad for equities and other risk assets once again? Fundamentally, the US economy does not appear as bad to us as markets fear, especially given the expected delay in Fed tightening.

Looking at the latest earnings reports, three quarters of US companies have exceeded expectations, but the hurdles were low. Reported earnings per share fell (see chart), dragged down by steep declines in the energy sector and somewhat less so in basic materials. Earnings also fell in industrials, utilities, financials and technology. We expect US earnings growth to continue to struggle as rising labour costs and increased corporate bond spreads bite into margins. In Europe, earnings per share fell by just over 10% YoY.


We have maintained our overweight in equities, not primarily for fundamental reasons, but mainly on tactical grounds. We think that market sentiment is overly pessimistic, that short positions are at extreme levels and that the sell-off is overdone.

We closed our long European small caps/short developed market real estate position. US real estate has benefited from the reassessment of Fed policy. In the near term, we expect the market environment to remain accommodative to real estate generally.

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Please note that this article can contain technical language. For this reason, it is not recommended to readers without professional investment experience.