Last week was another wild ride for financial markets. Stock markets notched up their sixth weekly fall in a row, the worst run since the financial crisis. But Friday saw a sharp rebound, raising the possibility that the worst of the correction may be over.
The S&P 500 has now fallen within a whisker of the traditional measure of a bear market. Since its peak at the start of the year, the US’s benchmark index has now fallen by 19.9%. The Nasdaq, which is more exposed to the tech stocks that have borne the brunt of the sell-off was down 30% at one stage.
So far, at least, this has all been about a reset of valuations. The US market now trades on a multiple of around 16.5 times expected earnings. That’s around a quarter below the high of nearly 23 times earnings that it traded at just over a year ago.
Many other markets are considerably cheaper than that. The UK market is barely into double digits as a multiple of earnings. So some braver investors are asking whether this is it. Has the correction run its course? Is this a buying opportunity?
That depends on the E part of the P/E equation. If the price of the market is where sentiment and earnings meet, then much now depends on whether profits can continue growing from here. In the US, earnings growth continues to be forecast at about 11% for the year as whole, which is a slowdown from the post-pandemic recovery but good enough to support prices at current levels.
In Europe, earnings season has also just come to a close with profits being delivered even more strongly than in the US and better than expected. For the first quarter to March, earnings grew by more than 40% for the 450 or so companies in Europe’s Stoxx 600 index. That was 20% better than forecast.
In part that’s been a consequence of the weakness of the euro and the fact that a high proportion of European company profits are made outside of the region. On translation back into euros they are boosted by a weak currency. Europe is also heavily exposed to the energy sector where earnings rose by more than 200%, much higher than expected.
Other reasons to think that the correction may now have gone far enough include a reduction in the number of investors describing themselves as bullish versus bearish. The ratio has not looked this extreme since the financial crisis.
Fund flows into equity mutual funds and ETFs have also now turned negative after two years of inflows. And the amount of margin debt - investors borrowing money to invest - is also in retreat after spiking in 2020.
All of these are good contrarian signals. The mood is gloomy and that’s often the precursor to a reversal. And that’s encouraging so-called corporate insiders, senior executives who have to disclose their share dealings in their own companies, turning more positive.
So, that’s the stock markets. What about the other key asset class - bonds? Here there has been a key difference between government bonds, the value of which is largely determined by interest rates, and corporate bonds, which also price in expectations about the outlook for companies’ profits.
Until recently, it was government bonds that suffered as anticipated interest rate rises were priced in, while the strong outlook for corporate earnings meant that investors demanded relatively low compensation for default risk. Well, that has changed recently as concerns about recession have mounted. The so-called spread, the gap between safe government bond yields and those on riskier corporate bonds, has widened significantly.
And because bond prices move in the opposite direction to bond yields that has been bad news for bond investors. The proportion of bonds trading at a big discount to their face value has soared.
Investors are starting to worry that currently high profit margins cannot go any higher and, in fact, are likely to be squeezed as rising inflation increases companies’ costs while consumer sentiment declines as the cost of essentials like heating, fuel and food go up.
Inflation continues to dominate the economic news. This week, it’s the turn of the UK to report what is likely to be an eye-wateringly high number for the consumer prices index. CPI is forecast to hit 9% this week, on its way to a peak for this cycle of 10% or more in the autumn when further energy price hikes fare factored in.
Compared with the Bank of England’s 2% target that is a massive overshoot for inflation, on a par with that in the US where price rises recently hit 8.5%, albeit they moderated last week to 8.3%, the first sign that maybe inflation is peaking. In that context, it is perhaps unsurprising that the Bank of England is coming under fire from MPs looking for someone else to blame for the cost of living crisis.
Even though that 8.3% print for US inflation was a little hotter than forecast, there does seem to be a growing consensus that we have seen the worst of inflation. And that is starting to be reflected in expectations about just how far the Fed will need to go in terms of raising rates. As inflation expectations come down the real, inflation-adjusted level of interest rates increases. That will influence how far above the neutral rate of 2.5% or so the Fed feels it needs to push interest rates.
So for the first time this year, investors in both the equity and bond markets may start to feel marginally more positive. Markets always tend to overshoot so it remains a bold call just yet to be dipping a toe back into the market but peaking inflation, slightly lower expectations about the outlook for interest rates, and still reasonably strong earnings growth will help the feeling grow that the reset has gone far enough.
Of course, this does not mean that there are not still plenty of things to worry about. This week’s update from China showed just how severely the world’s largest emerging economy has been hit by the wave of lockdowns, including the one in Shanghai now running into its seventh week.
Retail sales, one of the most important measures of activity in a country looking to move away from its dependence on exports fell by 11.1% year on year in April. That was much worse than the 6.6% decline forecast by economists. Industrial production, which fuelled China’s rapid recovery from the pandemic two years ago, also dropped, by 2.9% compared with a forecast small rise.
Last week’s volatility was not restricted to mainstream financial assets like bonds and shares. Cryptocurrencies like bitcoin also experienced a roller-coaster ride with the price of bitcoin falling to $25,000 at one point on Thursday before bouncing back to $30,000 by the end of the week. That still represents a fall of more than 50% since the recent peak.
Bitcoin was widely touted as a safe haven in an inflationary environment due to the fixed number of coins in circulation - only 21 million bitcoins will ever be minted. Cryptos recent performance, however, has shown that it performs very much like other risky assets and it has been highly correlated with the performance of the most speculative parts of the stock market such as still unprofitable technology stocks.
Again, some investors will be asking whether the time has come after last week’s rebound to take another look. Certainly it is now possible to make a case for bitcoin on the basis of its relationship to the gold price and other measures such as the number of long term holders who are seen to provide support to the price. The reality is that crypto remains a highly speculative and volatile investment.