Stirring the pot
Bumps in the road
Summary
The resilience of markets, particularly equities, has surprised many, especially in the face of cuts to profit expectations and a mini-banking crisis. A number of risks could materialise and spoil the party: an earlier-than-expected and deeper-than-expected slowdown in demand, further woes in the financial sector especially related to the commercial real estate sector which is seeing valuations fall, and the ever-present risk of OPEC cutting oil supplies to drive oil prices higher and so ‘fuelling’ more inflation.
Expectations around corporate profits growth continue to be cut, leaving the US equity market in particular trading at full valuations. Profit margins are falling and until they stabilise we remain cautious.
In the current market backdrop, two drivers matter for markets: the forthcoming central bank decisions, and the likelihood, timing and depth of any recession, especially with respect to corporate profits.
Central bank tightening should be close to the end, but we are still uncertain on when that end will come. The market still expects the Federal Reserve to cut interest rates from the second half of the year, which has continued to support equity markets.
If cuts were to occur because of a recession, it could spell bad news for risk assets. The other trigger for a cut, inflation declining to 2% or lower later this year, appears even more unlikely, albeit that would be positive for all assets.
We have just started the quarterly earnings season – which will not only inform as to the shape of the downturn and potential recovery, but also provide more data on how the banking sector is coping with the recent fall out. Analysts’ predictions for US corporate profits in 2023 have already fallen by 13% from their peak. We believe there is a risk that further cuts are likely, which leaves equities vulnerable.
Facts can change. Share prices and valuations can change even faster. And quite often they overreact, both on the upside and downside.
Caution remains our watchword. The path forward could be clearing with more optimistic minds spying a trough in some economic indicators, but the risk is that this may prove a false dawn as higher interest rates continue to bite into economic growth.
A risk reality check?
It is interesting to note that the US equity market has basically gone sideways for nearly a year, despite all the interest rate action and economic angst.
And with the recent rally there are signs that investor complacency has returned. The VIX index provides a guide to the expected volatility (or risk) priced into the US equity market. When it is elevated, as it tends to be during sell-offs, then it suggests that risk aversion is high.
Over recent weeks, with the rally in the equity market, the VIX index has fallen below 20. In our view this suggests that equity investors are complacent about downside risk in coming months.
Risk appetite may be tested in coming weeks as companies update the market about their outlook and profitability. The economic backdrop remains lacklustre with signs of a slowdown spreading from the housing market but there has been better news on inflation which may ease the pressure on Central Banks to raise interest rates much further.
After a small rise in volatility (a signal of risk aversion) around the banking crisis in the US, equity markets have rallied, and volatility has fallen suggesting a risk of complacency by investors.
Source: Bloomberg, Artorius
All expressions of opinion reflect the judgment of Artorius at 21st April 2023 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Nothing in this document is intended to be, or should be construed as, regulated advice. Artorius provides this document in good faith and for information purposes only. Reliance should not be placed on the information contained within this document when taking individual investments or strategic decisions. Artorius Wealth Management Limited is authorised and regulated by the Financial Conduct Authority. Artorius is a trading name of Artorius Wealth Management Limited.