Wednesday’s market sell-off is a painful reminder that the catalysts for equity weakness remain in place.
There have been five major factors driving markets lower and these all need close attention by investors in the coming weeks.
Future profits looking shaky
Let’s start with arguably the most underappreciated global market hurdle: the profit outlook outside of energy and agriculture sectors is deteriorating markedly. On the surface, first quarter S&P 500 earnings are looking solid with consensus earnings estimates higher by 6 per cent, all 11 sectors exceeding forecasts and 56 per cent of companies beating both sales and profit estimates.
Under the surface, however, there are problems. BofA Securities U.S. quantitative strategist Savita Subramanian analyzed executives’ earnings conference calls and discovered that mentions of “weak demand” jumped to the highest levels since the pandemic-ridden second quarter of 2020.
Earnings guidance, the ratio of companies raising profit guidance versus those reducing forecasts, and corporate sentiment, have all dropped to early COVID levels. Many more companies are lowering guidance than raising it.
The outlook for the megacap technology stocks that drove the rally has dimmed considerably – Ms. Subramanian notes that technology earnings as a percentage of the S&P 500 total have dropped below where they were at the end of 2020.
Signs of economic slowing
Slowing global economic growth, thanks in large part to the drastic lockdowns in China, is the second reason for market weakness. James Rossiter, head of global macro strategy for TD Securities, bluntly described the trend in a May 3 report in which he wrote, “Our high-frequency [economic] activity indicators are screaming ‘slowdown’ across the board.” His tracking of global growth suggests there was a sharp slowdown in this year’s first quarter.
The weakness clearly extended into April. The J.P. Morgan survey of purchasing managers in manufacturing sectors found that April global manufacturing output contracted for the first time since mid-2020.
Real yields have turned positive
Inflation-adjusted or real bond yields have been an important and accurate indicator for equity market action for the past five years. When real yields were mired near negative 1 per cent for much of the pandemic, potential bond investors were faced with the prospect of losing money annually once inflation was taken into account. As a result, many were attracted to equities, and particularly high-growth technology stocks, and this helped push stock prices and price-to-earnings ratios higher.
Inflation-adjusted bond yields, as measured by 10-year U.S. Treasury Inflation Protected Securities (TIPS), have moved rapidly higher this year – from minus 1.1 per cent at the end of 2021 to the current 0.3 per cent. The average P/E ratio of the technology-heavy Nasdaq 100 has fallen in accordance, dropping from 30 times to 22 times earnings for the same time frame. The Nasdaq 100 index is down 24 per cent year-to-date.
Central banks losing appetite for bonds
Matt King, global market strategist at Citigroup, has long believed that central bank quantitative easing has helped drive stock markets higher. He grants that the mechanism by which this happens is up for debate. (For instance, the proceeds from Federal Reserve open market purchases of bonds are held at the Fed, and can’t be invested or used as collateral by the receiving banks, so the funds never enter the market directly) but he has uncovered a compelling correlation between global quantitative easing and equity prices.
With central banks now removing QE and excess liquidity, the same pattern that pushed markets higher is now working in reverse.
Tighter financial conditions
Tightening financial conditions is the fifth major reason for market volatility. The Goldman Sachs U.S. Financial Conditions Index (FCI) uses bond yields, Federal Reserve policy rates, corporate bond spreads (corporate bond yields relative to government bonds yields) and the trade-weighted U.S. dollar index to measure the monetary liquidity conditions in markets.
The S&P 500 has consistently moved in exactly the opposite direction of the FCI. This was great when the FCI was falling hard from March 13, 2020, until the end of 2021. But rising bond yields and widening spreads have pushed the FCI higher in 2022 and stocks have moved lower at the same time. The excess market liquidity of the pandemic period is ending.
It is unfortunate that the most important of these market hurdles, fading earnings revisions ratios, are the hardest to track and Goldman Sachs’s financial conditions index is also difficult to find. Real rates as measured by 10-year TIPS yields, however, can be followed on the Federal Reserve Economic Data site and global purchasing managers’ index (PMI) results are available from numerous sources.
-- Scott Barlow, Globe and Mail market strategist
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Question: Prime Minister Trudeau now proposes a new tax on our banks. How will this impact share prices of our leading banks? – Robert A.
Answer: Not much. In the grand scheme of things, the tax is small in relation to bank profits. Plus, the move had already been signalled in the Liberal campaign platform, giving the markets plenty of time to respond. Stocks of most banks actually edged higher in trading on the day after the budget was presented.
The greater concern is the potential slippery slope this initiative creates. Why stop at banks? The government doesn’t like conventional energy companies, so why not impose a special tax on their profits? Or the telecom oligarchy?
Businesses hate uncertainty, especially when it comes to making investment decisions. Imposing targeted taxes on individual industries is a highly questionable policy for a country that wants to encourage investment and growth.
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