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What’s needed to launch equities?

06 September 2019

4 minute read

By Julien Lafargue, CFA, Head of Equity Strategy

After a sharp correction in US equities during August, strong gains in equity markets seem reliant on central bank policy easing or a positive breakthrough in US-China trade tensions.

Last month we argued that equities were at a tipping point and likely to witness increased volatility as investors’ sentiment swings between fears of recession and anticipation of central banks’ support. This seems to be occurring. So just how long will equity markets have to wait to break substantially higher?

Upside in equities conditional

Although heightened trade tensions and worrying recessionary signals sent by the fixed income market caused the S&P 500 index to lose 6% peak-to-trough in August, our view remains unchanged. Broad-based upside will only come if we see progress on the trade front and/or a “shock and awe” central bank easing on the monetary policy front.

On the former, it is hard to imagine that a deal between the US and China will be struck soon. A truce would be welcomed but it may come too late to restore business confidence. In this context, equities may see a short-term re-rating on any good news but this will likely be offset by lower earnings growth in the medium term as companies continue to delay investments.

Monetary policy is, in our view, what could help markets break above the current trading range. Yet, expectations already look high, leaving little room for positive surprise. With interest rates making new historical lows, central banks would need to deliver significant easing packages for markets to take notice. This may be in the cards in Europe soon, but it will likely take much longer before it materialises in the US. In this respect, September will clearly be an important month.

Monetary policy is, in our view, what could help markets break above the current range. Yet, we believe that expectations are high already, leaving little room for positive surprise.

Recession risks overplayed

Importantly, despite the deafening noise caused by the inversion of the 2-10 years US interest rate curve in August, when the longer-dated 10-year bonds yielded less than the shorter dated 2-year ones, we believe that a recession is still far away.

While we would not completely dismiss this above signal, there are solid arguments as to why “this time is different”. We believe this has nothing to do with where interest rates are or that inflationary pressures remain absent.

Why this time is different

What really differentiates this cycle from others is the extent of involvement by central banks.

What really differentiates this cycle from others, in our opinion, is the extent of involvement by central banks. There is now a buyer of last resort. While this may not prevent the next recession, as it does little to support economic growth, from an equity market perspective it should help soften the blow.

The involvement of central banks does not mean that the market will not experience significant drawdowns. However, we expect them to be relatively short lived as long as market participants keep faith in central banks’ ability to save the day.

Focus on sector and stock opportunities

In terms of investments, this means that staying invested remains the best course of action, in our view. In the short term, equities may struggle to break out of their range and volatility may stay elevated. But as we’ve learned, going against central banks is often a losing proposition. Instead, we continue to focus on improving the risk-reward profile of portfolios and finding opportunities at the sector and stock-specific level.

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Market Perspectives September 2019

Find out our latest key investment themes. Expectations of more dovish central bank policy could do nothing to prevent a sharp, negative, swing in senitiment in August as recession fears returned to markets. Furthermore, US-China trade tensions seem unlikely to be resolved soon.

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