The US S&P 500 rose 7% in October to a new peak after 83% of its constituent companies beat analysts’ expectations in the third-quarter earnings season, while the global benchmark MSCI World Index gained 5.8%.
The rises came despite fears over higher energy prices hurting consumer spending power, lower growth in China and the inversion of the long end of the US yield curve which traditionally signals an upcoming slowdown.
Bond market turmoil can be a bad omen for growth stocks as they are highly sensitive to rate rise expectations, worsening inflation outlooks and any tapering of stimulus programs from central banks. All these scenarios would theoretically be negative for the discounted value of future company profits.
“Late October saw a surge in front-end interest rates and a bear flattening of the US yield curve,” says Peter van der Welle, strategist with Robeco’s Global Macro team. “The very long end of the curve even inverted, signaling potential trouble ahead for the business cycle.”
“The recent inflation scare led to frontloading of expectations for rate hikes and balance sheet reductions by central banks. Historically, there is a positive correlation between the shape of the yield curve and the subsequent earnings outlook.”
Van der Welle says they are three reasons why stocks have been largely undeterred by this, led by the onward march of US companies.
“First of all, the Q3 earnings season shows that corporates are taking rising input costs largely in their stride, with profit margins overall increasing to 12.4% against expectations,” he says. “In contrast with the previous earnings season, the 83% of S&P 500 companies beating expectations also saw positive stock price reactions.”
“Second, despite the turmoil in the bond market, US real rates have remained in deeply negative territory, sustaining elevated equity price/earnings multiples. Third, the growth signal from the recent yield curve flattening is perhaps weak as this harbors technical factors such as buying by derivative traders and significant month-end rebalancing.”
Much of the rise in stocks has been due to earnings recovering on the back of pent-up demand by consumers now that the Covid-19 lockdowns have been mostly unraveled. And they have money to spend.
“The outlook for the developed market consumer still looks bright given improving labor market prospects, the current level of excess savings and historically high net household wealth,” says Van der Welle. “This should underpin top-line growth for corporates.”
But there are also downsides, led by higher energy prices eating into spending power, and problems in China, which as the world’s second-largest economy and engine of global growth remains a potent force.
“Declining consumer sentiment levels suggest that some are starting to balk at elevated energy and consumer good prices,” Van der Welle says. “Also, the Chinese economy, which accounts for 30% of global growth, is showing signs of increasing contraction.”
“There is no evidence yet of strong monetary easing to counteract the current slowdown resulting from a regulatory crackdown within China and the energy crunch, so this remains a relevant worry for us in the near term.”
“The market could underprice this risk as a contraction in Chinese growth will indirectly hurt global equity markets. Some local emerging market equities derive 25-45% of their revenue from China, but even some sectors in the US are not immune, as a sizeable chunk of their revenues also come from China.”
Then there is the long-awaited withdrawal of the stimulus measures that kept economies afloat during the pandemic. “There has been a strong correlation between central bank balance sheets and equity market performance, driven by underlying expansion of price/earnings multiples in the past decade,” he says.
“With the Fed likely to start tapering its bond purchases by mid-November, the tide of almost unlimited excess liquidity is slowly starting to recede, while other developed market central banks are already embarking on a policy rate tightening cycle.”
In all, investors should enjoy the rally while it lasts, but be wary of negative macro forces finally getting the upper hand, he says.
“In the next 6-12 months we expect equity valuations to become more sensitive to a modest rise in real interest rates,” says Van der Welle. “Absolute equity valuation levels still point to stocks being very expensive, with the Shiller CAPE now at 39, a level only observed during the heyday of the IT bubble in 2000.”
“In contrast with then, real rates are expected to remain subdued while equity risk premiums are much higher compared to 2000 levels, limiting downside risk. Nonetheless, we still need more clarity on the Fed, some evidence that the China credit impulse is bottoming out and receding stagflationary sentiment in the bond market before becoming more bullish.”