The US equity market has rebounded some 15 percent from its low in June, helped by hopes of a Fed turnaround, better-than-expected corporate results and investors who were gloomy but invested.
The June low remarkably coincided with the peak in earnings expectations for 2022 and 2023. This means the entire price recovery can be attributed to higher valuations, made possible by lower interest rates. The fact that corporate earnings were better than expected, however, says more about expectations than about the underlying earnings trend.
Earnings estimates for 2022 have fallen by 1.5 percent since the end of June, while earnings estimates for 2023 have fallen by 3.5 percent over the same period. As a result, the valuation for the S&P 500 has risen from 15.4 at its June low to 18.4 at its recent August high.
Watching Jackson Hole
This increased valuation puts the stock market on edge ahead of Thursday’s Jerome Powell speech at the Jackson Hole meeting of central bankers. Against the backdrop of the Grand Teton national park, those present were able to read last week that the US economy is not doing badly at all. The market was expecting a decline in retail sales, but it turned out to be the sixth increase in a row. Apart from cars and fuel, just about every category rose. Excluding cars and energy, retail sales are now up 8.7 percent over the past year.
The development of the number of jobs and hourly wages may not be a predictive indicator, but they were certainly figures that point to a recession. Moreover, with an average wage increase of 6 percent, it will be difficult to reduce inflation to 2 percent. The purchasing managers› index in the services sector (the largest part of the economy) also came out higher than expected.
Here, too, a figure of 56.7 does not indicate an impending recession. If the Federal Reserve does what it says and only looks at the most recent data, it should raise the policy rate by at least 0.75% in September. Cautiously, the market is beginning to feel this. Interest rates are rising and the dollar-euro parity has been broken.
Improving financial conditions frustrate the Fed
It is striking to what extent financial conditions have improved in recent months. Since the Great Financial Crisis there have been various indices measuring financial conditions. Usually it is a combination of interest rates, credit spreads, equity markets and volatility. The improvement in financial conditions has made possible the recent rally in equities.
At the same time, this development is frustrating Fed policy. Even more extreme are the results in the St. Louis Fed Financial Stress index. It is at its lowest level since 1994. This index is made up of 18 different weekly data sets of interest rates, credit spreads and five other indicators. Each of these components provides insight into the level of financial stress, which is now extremely low.
In the months of June and July, bad news for the economy was good news for the financial markets. This allowed interest rates to fall, from which valuations benefited. If Powell is convinced that the Federal Reserve needs to do more to curb inflation, he will have to bring about a deterioration in financial conditions, among other things. This will require credit spreads to rise and equity markets to fall.
Any other message at the end of the week will be oil on the fire. It would lead to a renewed rise in inflation expectations, which would further undermine the Fed’s credibility. The Fed has no choice but to push for a deep recession and, given the strength of the US economy, interest rates need to be raised to match it.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co.
This contribution originally appeared in Dutch on InvestmentOfficer.nl.