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Dark clouds ahead?
29 Jul 2016
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 Friday 29 July 2016

Dark clouds ahead?

 

 

As we head into month-end, we also approach the height of summer. August is typically a time for light trading volumes as many market participants step away from their screens and head for holiday destinations instead. But it can also be a difficult time for equity markets.

Looking at the major US stock indices since the end of the financial crisis, we’ve seen significant August sell-offs in 2010, 2011, 2013 and 2015. In 2012 the sell-off came in June and in 2014 it happened in July. This year there has only been one negative month and that was in January. So is it time to exercise some caution now?

On the plus side, the Federal Reserve looks like holding off from hiking rates this year. That should offer support for equity markets. However, the Fed has also gone to great pains to express its confidence in the US economy. It paints a picture of a Goldilocks scenario where US growth is picking up yet the Fed can afford to hold back from tightening monetary policy as it assesses the mixed signals coming from other global economies.

But there are two problems with this assessment: firstly, as is clear from the ongoing second quarter earnings season, US corporations are struggling to make much headway when it comes to improving earnings and revenues. If this season continues as it began, we’re set for a fifth consecutive quarter of year-on-year earnings declines, and the sixth of revenue declines. This is a problem when the major US indices are trading close to their all-time highs. Basically, US stocks are looking expensive. Secondly, today’s second quarter GDP reading was a disaster, showing growth of just 1.2% on expectations of 2.6%. Remember: this is an annualised figure and comes as we are well into the seventh year since the nadir of the financial crisis and the unprecedented monetary and fiscal stimulus which followed it.

Equity markets continue to shrug off bad news. One of the main reasons for this is that investors are desperate for yield. They can’t get anything meaningful in the bond market so they look to equities for dividends and the hope of capital gains. Of course, equities are higher risk than bonds, even bonds with negative yields. But when investors believe that central banks will always step in and prevent any significant sell-off, they’ll tend to buy dips rather than sell rallies. And it has worked very well so far as the chart below of the Dow shows. But we are overdue a bit of a shake-out, and it could be that traders use the next few weeks to test the Fed’s resolve. 



 

Posted by David Morrison

Tagged: Bulletin

Category: PM Bulletin


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