At first glance the background for equities looks fine. Global growth is holding up, the latest US figures strong labour market. The fear of a credit crunch in the US is fading and the debt ceiling issue has been resolved. Inflation is falling and, in Europe and the US at least, core inflation is also edging lower. Many hope that interest rates are close to a peak.
Despite this, we think equities are likely to struggle over the balance of the year. First, although the US payroll numbers were strong, there are several signs that point to weakness ahead. Survey data suggests that hiring intentions have declined significantly. Also, some statistical distortions appear to have boosted recent figures – and these are set to reverse in coming months. US corporates have been suffering a margin squeeze, which typically leads to job cuts. The credit crunch may have been averted but there is still a credit squeeze with both the demand for and supply of credit under pressure. And while the inflation background has improved in the US, service sector prices are still firm with further rate hikes seemingly necessary for the Fed to hit and maintain its 2% target.
All this suggests that corporate earnings will come under renewed pressure. The recent reporting season for S&P 500 companies did produce better than expected numbers but those expectations had been heavily reduced head of time. Earnings still ended up lower than expected weeks before the numbers were released.
In addition, the rise in real interest rates requires a lower valuation for risk assets. The yield on US Treasury Inflation-Protected Securities is now 1.6%, up from -1% when the Federal Reserve were buying bonds under its Quantitative Easing programme. That is now going into reverse. But US equities are far from cheap: the price to earnings ratio for S&P 500 companies is nudging 20 on both a trailing and prospective basis. The well-known meteoric rise of a handful of mega tech companies has pushed the overall market higher. For the broader market, earnings expectations for 2023 have been cut but analysts expect a resumption of double-digit growth in 2024. That seems highly optimistic.
For all these reasons, we are taking a cautious view of equities from here and prefer the safety of bonds. We do not see a dramatic decline, but recent strength seems overdone to us.
