In an ideal world, especially given that the US has just raised interest rates, market watchers would be looking for signs of the type of margin expansion and earnings growth that would justify current valuations, but, in most cases, will probably settle for an indication that dividends remain resilient in the face of margin pressure.
Indeed, as David Jane co-manager of the Miton multi-asset range pointed out at the end of last week, the evidence suggests that the US is late in the economic cycle with credit conditions starting to tighten and corporate profits falling.
Going a step further he said: “. Even though we have only just seen the first rate rise, whether we slip into recession at some point in the current year is certainly not clear but we see this as a much greater risk than for some time.”
But, he added, on the other hand “it is equally plausible that we are in a brief growth slowdown and that the US economy and corporate profits re-accelerate once the negative drag of slowing energy capital spend and rising wages is absorbed into the system.
This sentiment is echoed by Bank of America Merrill Lynch. In its latest Thundering Word note, the bank writes: “Recession risks remain mispriced: profits are highly correlated with PMIs and in both US & China PMI’s are weak; upward momentum desperately needed to prevent global EPS downgrades.”
According to BAML “Classic cyclical signals such as the Dow Jones Transportation Index are in unambiguous bear markets, and are now dragging “new economy” indices lower”. As a result, it added, fresh downside to PMI numbers would be “very worrying” as “an ISM below the 45 level has coincided with an official US recession 11/13 times since WW2, is historically associated with (at a minimum) a 5-10% drop in profits, and should it occur in coming months, would be entirely consistent with 1.5% on the 10-year Treasury yield and 1800 on SPX.”
As a result of this, BAML is of the view that investors should look to be long cash & volatility and be prepared for a short sharp pullback in risk assets.
However, it did add, as a caveat that this is the move “at least until one of the following conditions are met: PMIs rise back above 50 in China and the US, 2-way risk emerges in CNY & oil inducing value buyers of HY & EM debt or a spike in volatility and/or an asset price reset induces Fed to pause.
