Churning away
Fundamentals pointing in different directions
Summary
There is growing evidence of a slowdown in the US labour market and signs of a credit system that appears to be entering a recession, whilst at the same time away from US smaller companies, profits appear resilient.
In the current market backdrop, two drivers matter for markets: 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 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, but with elevated inflation, it is hard to see policymakers cutting rates without a recession.
If interest rate cuts were to occur because of a recession, it could spell bad news for risk assets.
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.
Going nowhere fast?
Despite a war in Europe, higher interest rates and a reduction in earnings expectations for 2023, the US equity market is at a similar level as it was twelve months ago. The roller-coaster ride in between times appears to be waning but the jury is out about the next move.
The combination of elevated valuations and policy risk points to a cautious stance for now.
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.
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
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