Economic data may point to a favourable bounce for investors midyear, but market risks remain

The Chinese and US economies will see growth stabilise, not pick up or drop significantly. Meanwhile, company earnings will have to bottom out or even rise to calm investor nerves

Kerry Craig

Published: 11:00am, 5 Apr 2019

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During a game of rugby, players will often chase long kicks downfield to get behind the opposition’s defensive line. If the player can recover the ball, this can be a great strategy, but the oval shape of ball, which allows it to bounce at unexpected angles, makes this challenging. However, a perfectly timed kick and chase when combined with a fortunate bounce that sees the ball rise to the perfect height for the player can often look like sporting magic.

After a strong rally in global equity markets this year against a backdrop of deteriorating economic data, market watchers are looking for a favourable bounce of their own in the form of a pick-up in economic momentum. However, a stabilisation in growth is more likely than significantly higher or lower rates from here. This is down to the ongoing stimulus in China and the pause in interest rate increases by the US Federal Reserve.

The promise of further stimulus measures from Beijing was the fuel markets needed to rocket away from last year’s lows. Further fiscal and monetary policy measures are expected over the year, as local bond issuance is increased to fund infrastructure projects and the People’s Bank of China continues to trim the reserve requirement ratio for small and large banks, to promote lending.

The standing of the Chinese economy can be fuzzy around the start of the year because of the Lunar New Year, but the purchasing managers’ index for manufacturing nudged back into expansionary territory in March, indicating that the slide may be drawing to a close. The enhanced stimulus measures, however, are unlikely to deliver a material pickup but rather create equilibrium around the 6 per cent growth target, given the more nuanced nature of the measures compared with prior episodes of fiscal largesse.

The US is also likely to find its feet at a lower but stable growth rate. This is simply because the tax changes introduced at the start of 2018 did an excellent job of boosting growth by raising the level of spending of small businesses and households for a period, but it was never going to be permanent. The economy will revert to its late cycle growth rate as the effects wear off.

Meanwhile, the economy is not at risk from an aggressive Fed ending this cycle too early. Since 2015, the Fed has raised the level of interest rates from a target band of 0-0.25 per cent to 2.25-2.50 per cent, or by 0.75 percentage points per year on average. This is one-third of the pace of the average tightening by the Fed in the past five hiking cycles.

The Fed isn’t going to slow the economy with this pace of tightening or level of interest rates. With inflation close to 2 per cent and the labour market at full employment, the central bank isn’t touching the brakes on the tightening cycle because it fears crashing the economy but, rather, because it’s approaching its destination.

Jerome Powell, chairman of the US Federal Reserve, tours the mHUB Innovation Centre in Chicago, Illinois, on April 6, 2018. Photo: Bloomberg

So what about the shape of the yield curve? There has been a plethora of commentary around what the inversion of the US yield curve really means and whether this is truly a sign of an impending recession. If we rely solely on historical precedent, then an inverted yield curve is a very strong signal of a recession, given that it reflects very weak growth and inflation expectations. But when viewed in the context of the structural changes and how monetary policy is enacted through higher central bank balance sheets, the signal is not as clear.

The yield curve remains a barometer for the economic climate, but the takeaway is that economic growth is cooling rather than freezing.

The momentum in the global economy is central to many investors. Equity prices have been rising as earning expectations have been falling, resulting in valuations based on forward price-to-earnings ratios moving back to long-term average levels. To satisfy investor nerves, the downgrade in corporate earnings estimates would need to find a bottom or even turn higher. This largely depends on the outlook for growth and how much company revenues can drive profits as factors such as higher wages start to erode profit margins.

Investors may see a favourable bounce as economic activity stabilises into the middle of year, but with risks to markets and growth still prevalent, it may be better to adopt a more prudent strategy to win the game.

Kerry Craig is a global market strategist at JP Morgan Asset Management

This article appeared in the South China Morning Post print edition as: Investors may see a favourable bounce but market risks remain

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