Four years and counting

The bull market is four years old this week. The MSCI World index fell 27% in 2022 as central banks tackled the post-Covid inflation surge with higher interest rates. Since then, it has more than doubled.

It’s been a strong rally but not an unusual one. The 119% gain for global shares in 48 months compares with an average 101% rise in 39 months.

Not unusual in length or strength, then, but notable for its dependence on one powerful theme and for the narrowness of market leadership.

The rise in stocks since October 2022 has relied on the biggest US shares and the persistence of the AI boom, which continues to underpin strong earnings growth.

At the broader market level, it’s been less exciting. The equal weighted S&P 500 index is up less than 50% over the period. Well below average.

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How high is too high for bond yields?

With 10-year bond yields safely into the danger zone above 5%, the question for equity investors is when a rising cost of borrowing will start to hit company profits and market sentiment.

For now, buoyant earnings growth means investors are shrugging off tighter financial conditions. And with third quarter earnings season about to unfold, the outlook remains positive. If recent history is anything to go by, an expected 25% rise in profits could turn out to be higher still by the time all the numbers are in.

It’s that stellar growth in earnings that is keeping valuations in check. At less than 20 times earnings, the US market is expensive but not excessively so, and most of the rest of the world is much cheaper still.

But history also suggests that investors usually prefer to cut the amount they will pay for high earnings growth long before a slowdown in profits growth actually arrives.

If investors feel that earnings growth is unsustainable, they will demand compensation for the likelihood of a slowdown. In the past, today’s level of earnings growth has led to a price-earnings ratio in the low, not the high, teens.

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The week ahead

Earnings are one of the key features of the week ahead. As usual it will be Wall Street’s big banks that kick the season off, with results in the next few days from JP Morgan, Goldman Sachs and Bank of America.

These will most likely be strong again, on the back of the AI boom - rising share prices, takeover and flotation work and cash raising in the bond market.

The question, then, will be how much further than the obvious AI beneficiaries the earnings boom can spread in an environment of higher bond yields and labour market fragility.

On the data front, there’s plenty to watch out for too. In America, it’s all about inflation this week. The headline level of CPI is expected to rise from 3.4% to 3.7%, but the core level, which strips out volatile energy costs, will only nudge higher from 2.4% to 2.5%.

That could be enough to stay the Fed’s hand this month. Futures markets signal just a 19% probability of another rate hike in October. But a further rise is all but fully priced in for December.

Here in the UK, the focus will be on growth in the economy, with GDP data expected to be flat for August after strong growth in July. The first three quarters of the year have enjoyed surprisingly resilient growth. Further out things look less secure as mortgage rates rise and the jobs market looks sluggish.

That will be the tricky backdrop to Chancellor John Healey’s first Budget on the 28th of this month. Rising bond yields have narrowed his room for manoeuvre and he faces difficult tax and spending trade-offs in two weeks’ time.

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