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We remain optimistic for further equity growth but cautious about interest rate rises.

  • Friday, February 23, 2018

Busy trading floor of the New York Stock ExchangeAfter a week of stock market falls, equity markets have since settled and are now more confident. The minutes of last month’s US Federal Reserve (Fed) meeting were released on Wednesday. Fed funds interest rate futures suggest a 25-basis-point hike next month is a certainty, no doubt driven by the recent fears about accelerating inflation. Last week’s US inflation numbers came in higher than expected at 2.1%, driving the 10-year treasury to 2.9%, which is a four-year high, before it settled lower. This was coupled with the University of Michigan US Consumer Sentiment survey hitting a high 99.9, up from 95.7 and easily beating the 95.5 expected.

There has been confidence about the strength of the US economy for some time now. Expansion here should provide a strong base for global commerce; improvements in the Eurozone and continued demand form China’s ever-growing middle class will only help this. Whether this environment will be good for the American stock markets is tough to predict. Corporate earnings – which are already a larger proportion of GDP than they have been on average over the longer term – will have to go even higher to offset higher interest rates and the more aggressive discounting that accompanies monetary tightening. US public companies have certainly delivered the goods this quarter. According to FactSet, three-quarters of S&P 500 stocks reported higher earnings than analysts had hoped for. Even more beat sales forecasts. About 80% of the index has reported so far; if the 78% of companies surprising on sales numbers holds it will be the highest proportion since FactSet started measuring. Similarly, if the blended earnings growth stays at 15.2%, it will be the best quarter since late 2011.

The effects of the Trump tax cut will be complicated for some firms, but in the main it should be a tailwind for US businesses. Whether that will foster a strident response from the Fed is as yet unknown. This risk is hanging over markets right now. At a time when earnings are looking strong, the economy is humming and cash is plentiful, the forward P/E of the S&P 500 is 17.1x. That’s only slightly higher than the long-term average of roughly 16x. Clearly there is a risk that the Fed will make a monetary policy blunder. Its long-term interest rate forecasts are noticeably above those of the market and at a level that would suggest dampening the business cycle. However, these forecasts may yet be revised down, and the effects of overly quick tightening would take 18 months to feed through to the real economy. In short, we can see storm clouds in the distance, but the next year or so should yield acceptable returns.

We remain optimistic for further equity growth due to global growth factors but cautious over the impact that future interest rates will have upon equity valuation particularly with such indebtedness in the world economy.

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Chris Davies

Chris Davies

Chartered Financial Adviser

Chris is a Chartered Independent Financial Adviser and leads the investment team.

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