IT’S A ROCKY ROAD AHEAD FOR RECOVERY
JANE FOLEY
RESEARCH DIRECTOR,
FOREX.COM
FOLLOWING a pullback in early July, the S&P 500 has forged ahead this summer, lifted both by a round of earnings reports in which over 70 per cent of US companies beat estimates and some better news on the global economy. The rally in stocks has coincided with a rally in other “risk” trades. But the question for equity markets and other risk trades now is this: has the improvement in demand and in the economic backdrop in general been sufficient to justify these rallies?
The sharp contractions in US real GDP in the first and second quarters of this year resulted in a spate of very cautious forecasts for second quarter earnings. While the indications for earnings were poor, the caution on which the estimates were built should not be discarded. Cost cutting was a central element to the better-than-expected second quarter earnings reports. Clearly, cost cutting cannot be sustained indefinitely, and this suggests that if better earnings are to be extended through the third and fourth quarters, revenues need to improve. It is fair to assume that corporate revenues will improve as demand increases and that, generally speaking, demand will be linked to the pace of world growth. The outlook for global economic recovery thus remains central to the outlook for stock market indices, as indeed it is for all risky assets.
Strong improvement in growth in some emerging economies in the second quarter and positive GDP data in Germany, France and Australia confirms that the world economy is presently in a far better position than most people would have thought possible only a few months ago. This has provided the justification for the rallies in risky assets to date. In general, this better second quarter GDP data pays tribute to the success of government fiscal incentives.
But while the outlook has improved, most countries are far from being confident about the prospects of sustainable economic growth in the coming months. Countries such as Germany, China, South Korea and Singapore are among those who have reported much better than expected growth in the second quarter. All of these countries, however, are heavily dependent on export markets, which suggests their success in the coming quarters is still vulnerable. While more countries including the US, Canada and the UK could be growing again in the coming months, the road ahead looks rough and rocky. Crucial will be the pace with which trend growth can be regained, but at this juncture it seems likely that it will be some time before trend growth levels are seen again.
It is now commonplace for central banks to suggest that the declines in economic activity are levelling out. However, with the exception of countries such as Norway and Australia, which have been protected from deep recession by their natural resources, most central bankers continue to err heavily on the side of caution. Last week’s much weaker-than-expected performance of US retail sales in July – it fell 0.1 per cent month-on-month – is a clear reminder of the compromised position of the US economy and provides an apt illustration of the words contained in last week’s Federal Reserve policy statement that “household spending remains constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit”.
NECESSARY ADJUSTMENT
Bank of England governor Mervyn King painted a similar picture last week in his presentation of the quarterly Inflation Report, warning that during the course of his speech that the strength of recovery will be affected by a necessary adjustment of balance sheets of companies, household and banks. The BoE’s concerns about the economic outlook were severe enough to warrant this month’s unexpected £50bn extension to quantitative easing; a reflection perhaps on the fact that the UK is one of the few countries that underperformed market expectations in the second quarter.
What was also made clear by the BoE’s action is that medium-term inflation pressures are not a concern. Despite the huge liquidity injection, the implication is that the damaged balance sheets of the banks and households will ensure that the money multiplier stays broken for a long time yet ensuring that price pressures remain subdued.
While it seems likely that conditions in the global economy will continue to improve over the medium-term, allowing risky assets to perform better, this does not rule out intermittent corrective pullbacks. Historically, September is the worst month for the performance of stock market indices and following this summer’s rally, many market participants will be nervously watching the next round of economic data. Pullbacks should be viewed as potential buying opportunities.
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