WHAT’S the right level for the stock market in an environment of high inflation, rising interest rates and slowing growth? That’s the question that’s been preying on investors’ minds for a few weeks now. Fortunately, the re-set may be close to running its course.
First, the bad news…
Last week, Wall Street notched up its longest losing streak in a decade. Shares in both the S&P 500 and Nasdaq have fallen for five weeks on the trot. Those are the worst runs since 2011 and 2012 respectively.
Volatility has been high too, as investors have toyed with buying the dips but quickly lost their nerve and bailed out again. First, they welcomed the Fed’s 0.5% rate hike (it wasn’t the speculated 0.75% rise) but then another red-hot non-farm-payrolls jobs report pointed to plenty more rises to come. Wage growth is running at 5.5%. Bond yields have already got the message – the 10-year Treasury yield hit at recent high of 3.17% this week.
In the rest of the world, the problem is not just inflation but slowing growth too. The Bank of England warns that Britain could be in recession within a year – at the same time as inflation tops 10%. No wonder expectations of UK rate rises – they also edged higher to 1% last week – are starting to lag behind those in the States.
And that is feeding through to the currency market where the dollar is trading at a 20-year high. In part that reflects higher yields in America – making it more attractive to own US assets – but also the dollar’s safe haven status at times of economic stress.
…and the good news?
Well, it’s less obvious, but there are some straws for investors to cling onto this week. First, inflation data in the US this week may well show that price rises in America are peaking. Economists expect CPI to be 8.1% in April, a bit below March’s 8.5% reading although still close to a 40-year high. The core picture, excluding energy and food, may be more worrying, as rents continue to rise, but it would still be a welcome reminder that inflation doesn’t keep rising for ever.
The second bit of good news is that the poor economic backdrop is not yet showing through in corporate earnings, which remain the key determinant, alongside valuations, of where the stock market should be trading. With most of the S&P 500 constituents having now reported their first quarter results, the expectation remains that earnings will grow by 10% this year.
That should help offset any further reduction in valuation multiples which have been falling for over a year now as investors anticipated slowing profits growth. The US market trades on around 18 times expected earnings, about five points lower than a year ago. That ratio may have a bit further to fall, but the bulk of the reset in expectations looks to have taken place.
