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Goldilocks walks a tightrope

By Philip Lawlor, managing director, head of global markets research

The “just right” Goldilocks economic backdrop has been a major driver of global equity markets for the past several years. The recent dovish central-bank U-turn and easing trade tensions have fostered hopes that this benevolent combination of growth and inflation can persist.   

But, as our March overview of global market conditions indicates, the challenges to the Goldilocks scenario have risen. Mounting signs of slowing global growth and persistent geopolitical uncertainties pose greater hurdles for revenues and corporate profit margins—and, in turn, risk appetite.

Financial conditions are supportive

On the one hand, financial conditions have loosened globally, offering relief to markets worried about an imminent recession. Most recently, the European Central Bank joined the US Fed and other major central banks in taking a more accommodate stance. As the chart below shows, the easing has been most pronounced in the US, which scored 3.3 in both February and March on the FTSE Russell Financial Conditions Indicator (FCI), down from a peak of 3.9 in November. At 2.6, the Eurozone ranks as the most accommodative of the major regions. (FCI scores around 3 are viewed as neutral, while those above 4 have tended to signal tight conditions.)1

Growth losing altitude

On the other hand, recent economic news has not been encouraging. According to the FTSE Russell Economic Data Barometer (EDB), which tracks positive and negative surprises in monthly reported economic data using a Z-score methodology, macro data releases continue to fall short of expectations (see chart below). The US barometer weakened significantly over the past month, after turning negative a year ago. China’s EDB score fell back into negative territory after a brief positive reading in January.

Shortfalls in economic data have prompted further cuts to already low consensus expectations for year-over-year GDP growth and inflation in 2019 across the major economies. 

We note, however, the recent uptick in US market breakeven inflation expectations, largely in unison with rising oil prices, in what has been a historically strong correlation. Along with the February acceleration in US wage growth to 3.4%, these trends bear watching for their potential to impact market interest-rate and corporate profit-margin expectations. Further traction would diverge from market-implied expectations for interest rates, which have fallen significantly from their November highs following the Fed’s “patient” policy shift.

Looming top-line and margin risks

Lower 2019 growth and inflation expectations raise hurdles for revenues and profit-margin prospects globally. Indeed, consensus 2019 revenue growth forecasts have edged lower over the past three months (see chart below), with US small caps (represented by the Russell 2000) and UK seeing the steepest downgrades.

Likewise, consensus forecasts for 2019 EPS growth have also fallen sharply across the developed markets over the past three months, particularly for the US (see chart below). Projected growth for the Russell 1000 Index now roughly matches that of the FTSE World ex US Index, while analysts expect EPS to decline for the FTSE Japan and the FTSE Asia Pacific ex Japan Indexes. Despite consensus analyst projections for similar revenue growth, the Russell 2000 Index is forecast for greater EPS growth than the Russell 1000 Index.  

For most business sectors, consensus estimates now indicate slower year-over-year growth in 2019 than previously projected. Based on FTSE World Index sector data, the downgrade toll has been most acute for the global oil & gas and technology industries, which are now seen posting EPS declines in 2019, rather than the strong gains projected just three months ago. Bucking the trend, forecasts have been upgraded for utilities and financials over the same period, with the former seen achieving double-digit EPS increases this year based on consensus analyst estimates. Current consensus analyst estimates imply significant margin erosion for health care, technology and oil & gas (as EPS lags revenues) and margin expansion for utilities, industrials and financials.

Valuations at a crossroads

The deteriorating revenue and earnings growth forecasts are a key market headwind. Global equity valuations, which have regained most of the ground lost in the Q4 downdraft but mostly remain below early 2018 peaks, should be assessed within the context of the evolving macro backdrop. 

To gauge the extent of changes in financial conditions across the regions, we use a Z-scoring methodology that compares the current reading of each variable against its longer-term average, measuring these divergences in terms of standard deviations, which are clustered into bands 1 through 5.

 

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