24th July 2014
Keith Wade, chief economist at asset manager Schroders, comments on the macro hurdles that he believes could challenge the continuation of the bull market and warrant a slightly more cautious stance towards equities…
With global growth continuing to recover and early signs that this is feeding through into emerging markets through stronger exports to the US and, to a lesser extent Europe, we think the most likely economic scenario is generally supportive of a pro-risk stance. However, there are two macro hurdles that could challenge the continuation of the bull market and warrant a slightly more cautious stance towards equities:
Federal Reserve tightens more rapidly than expected
We continue to believe that the unemployment rate will fall faster than the Fed anticipates. An acceleration in wage growth should follow and, whilst this would be good for the consumer side of the recovery, it will also bring greater inflationary pressure. We would expect the Fed to respond to this by ending QE in October and then raising interest rates from June next year with the Fed funds target ending 2015 at 1.5%.
Although we would not expect a repeat of the 2013 ‘taper tantrum’, anticipation of higher US rates is likely to check the search for yield and increase market volatility. We say ‘check’ rather than ‘stop’ as in real terms US rates will still be low and monetary policy elsewhere will remain easy.
Of course, as Fed chair Janet Yellen has clearly articulated, this cycle is different, with continuing headwinds acting on activity from the stock of outstanding public and private debt and the more cautious banking sector, which faces greater regulatory oversight since the crisis. Nonetheless, there is still the question as to how loose policy needs to be to compensate for these drags.
Our interest rate model suggests rates should already be rising and although this is based on the pre-crisis reaction function of the Fed, its message is still valid – i.e. US policy is very loose given where we are in the economic cycle.
Weaker profits growth
If wages are set to accelerate as we expect then we need to watch for pressure on corporate profits. This is the second challenge to the bull market in equities.
Productivity growth has helped offset cost pressures, but we now see employment accelerating and expect output-per-head to slow. When combined with rising wages, unit labour costs increase and thus squeeze margins. We would see this as consistent with a fall back in profits as a share of GDP.
Our model predicts a rise in operating earnings for the S&P500 of just under 7% this year with EPS expected to bounce in Q2 alongside the broader economy. Thereafter though as margins get squeezed, we expect growth to decelerate to 4% in 2015. Reported earnings rise 6% this year and next, reflecting a further decline in write-offs.
Although weaker, these earnings forecasts are unlikely to deter many investors. We would note though that with the turn in the interest rate cycle we are likely to see higher interest payments, which will also hit profits. The fall in interest rates has been a tail wind behind the corporate sector during the recovery, adding around 10 percentage points to corporate profits.”