Fundamentals Still Matter

    Michael Greenberg, CFA, CAIA

    Profile name

    Despite the recent mixed economic news, equity markets continue to hover around all-time highs, rebounding strongly after a dip in May. The weakness in May was prompted by softer economic data and the announcement that President Trump was moving ahead with tariffs on imports from China. Since then many forecasts for global growth have been lowered, including those from the IMF and our own Bank of Canada.1 The bond market has been signaling a slowdown for some time and it seems to be vindicated once again by recent data.

    On the corporate front, the data is also mixed. While earnings growth is not poor, it has been decelerating fairly broadly, except for the information technology sector. We are currently about halfway through the second quarter earnings reporting season and forward guidance has not been great with respect to sales or earnings growth for the remainder of the year. In addition, companies seem reluctant to increase capital expenditures which could further dampen economic growth.

    What’s driving this market

    So, what is driving equity markets higher? We think it has a lot to do with central bank policy. This graph shows that as market expectations for lower administered Fed rates took hold, equity markets spiked.

    In fact, since the trough in early June the S&P 500 Index is up over 7% (in US dollar terms) to July 25th.2 During the same time we have seen the price-earnings multiple increase from around 18x to almost 20x while earnings per share estimates were being revised downwards.

    The story is similar in Europe and the broader EAFE area. In June, Mario Draghi basically committed the European Central Bank to provide further monetary stimulus as risks to growth remain tilted to the downside.3 His comments led to gains in stock indexes.

    A dubious rally

    So once again, as we have seen before in this protracted market cycle, bad economic news becomes good news for the equity markets. It seems conversations are more what the Fed will do and not how individual companies are doing. We admit that easier central bank policy may fuel higher equity valuations in the short run and that it can be dangerous to “fight the Fed”. However, we question the sustainability of central bank induced rallies as economic and financial data deteriorate. We are also concerned about the effectiveness of each additional rate cut. There may be a diminishing effect as we approach the zero bound as that would indicate that economy is worse off than expected and recession risks have increased.

    In the short-term markets can be driven by different factors, but fundamentals will eventually rule the day and right now the fundamentals, while not dire, are looking weaker. This weakness, coupled with higher valuations than we saw last autumn when the data looked more robust, is causing us to be somewhat cautious on equities as we head in to the second half of the year. Therefore, we have been reducing our equity exposure, generally, and within this asset class are taking a more defensive posture.

    Ian Riach’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

    ENDNOTES

    1. See World Economic Outlook, International Monetary Fund July 2019 and Bank of Canada Monetary Policy Report July 2019

    2. Source: Bloomberg

    3. See European Central Bank press conference June 6, 2019