Every now and then, we all need to take a breather. That is exactly what the US equity market seems to be doing right now.
The recent sell-off at the start of March means the S&P 500 was flat for the year by the middle of March: this does not compare favourably to European and Japanese equities. The German DAX has gained more than 20 per cent and the TOPIX 11 per cent. However, after posting double-digit returns for four out of the past five years, a bit of pause in US stocks is not unwarranted.
This pause in the relentless grinding down of US stocks is due to the drivers behind the possible weaker growth outlook, the uncertainty over the timing of the first rate hike by the US Federal Reserve in many years, and the implications of a persistently stronger dollar for the economy and equity markets.
The growth outlook has become less certain with nearly every economic data release – except labour market data – coming in below consensus estimates. Retail sales have missed expectations for the past three months, bringing into question the consumption-fuelled boom that should come from lower fuel prices. The numbers may be being distorted by the weather and certain methodological factors, and forecasts for first-quarter economic growth are being revised down. However, the unemployment rate continues to decline and wage growth is showing signs of firming, suggesting that the Fed could move sooner than the market expects.
The first rate hike is likely to play emotional havoc with many investors. The Fed last raised interest rates almost a decade ago in June 2006. This means that there are traders and investors who are young enough to have no experience of such an event. No matter how much guidance the Fed provides, a rate hike will still be a complete unknown for some.
A strong dollar is not a problem for the US, but a too-strong a dollar is. A stronger dollar is a sign of a healthy economy and demand for US assets, but the sharp appreciation in the greenback is now curtailing earnings estimates. When measured against a basket of major currencies, the dollar has gained 15 per cent in real terms over the past year. The impact of the dollar on earnings revisions is one reason for the pull-back in US equities as it is leading to downward revisions to companies’ earnings estimates for the year ahead. Furthermore, the decline in earnings expectations becomes that much more difficult for market participants when the valuations are above fair value. The S&P 500 has a forward price/earnings ratio of close to 17x, above its long-run average, and the higher valuation makes investors more sensitive to market movements.
Interestingly, the word “patient” was removed from the Fed’s statement with reference to rates on Wednesday, as signalled during the testimony of Federal Reserve chairman Janet Yellen in front of Congress in February. However, following Wednesday’s statement, she told a press conference: “Just because we removed the word ‘patient’ from the statement does not mean we are going to be impatient.” The Fed may have also lowered its growth and inflation forecasts, indicating a very slow and gradual path for interest rates. While higher interest rates will no doubt lead to a spike in volatility, it is unlikely to not create a bear market. A little more clarity about the Fed’s plans – combined with a stabilisation in the US dollar, and therefore earnings – will restore investors’ faith in the US market. Getting over the hurdle of that first rate hike will be the best thing for markets.
