By Philip Lawlor, managing director, head of global market research
Fear of US Fed overtightening was a major catalyst behind the global market spasms late last year. The good news is that financial conditions have broadly loosened since then, particularly in the US, bringing relief to nervous markets and powering the recent risk rally.
As we highlighted in our latest report on the global equity markets, the multi-metric FTSE Russell Financial Conditions Indicator (FCI) score for the US declined to 3.3 in February from a peak of 3.9 in November, while scores of other major markets have also fallen (see chart below).1
We view FCI scores of around 3 as a neutral reading, while those above 4 signal tight conditions.
A major reason for the broad FCI declines was the pullback in market interest-rate expectations, as implied by 12-month-forward overnight indexed swap rates (see chart below). The drop was particularly pronounced in the US. The narrowing of US corporate bond spreads and the softer US dollar also helped bring down the US FCI score.
The downturn in rate expectations comes as several major central banks join the US Fed in putting their tightening agendas on hold amid mounting threats to the global growth outlook. This wariness has been reinforced by the recent round of cuts to 2019 consensus GDP and inflation forecasts across the major economies, which had already been anticipating a significant slowdown from 2018 levels.
Year-over-year GDP growth is expected to fall most steeply for the Eurozone (especially Italy) and the US in 2019 − although the US growth rate is still seen exceeding that of the Eurozone by one percentage point. Nonetheless, current estimates suggest that fears of a 2019 recession are premature (except in Italy).
As indicated by our newly introduced Economic Data Barometer (EDB), which tracks positive and negative surprises across a wide range of reported economic metrics and regions, disappointing macro news has been the norm for the past year (see chart below). Although somewhat improved recently for the US and China (albeit still in negative territory), the EDB score has deteriorated markedly for the Eurozone.
Lower GDP growth and inflation would mean lower nominal GDP growth, which has been a reliable proxy for revenue growth. Indeed, consensus 2019 forecasts look for revenue growth to drop by nearly half for the Russell 1000 and Russell 2000 Indexes, to slow even more sharply for Asia Pacific ex Japan and to turn negative for the UK (see chart below).
Lower revenue growth, in turn, implies stiffer hurdles ahead for operating leverage and, in turn, risks to earnings forecasts. These are classic late-cycle economic signals. History suggests that it may be time to employ a “top-down” approach to modelling the future trajectory of earnings rather than relying on “bottom-up” analysis, which have typically been slow to respond to macroeconomic turning points.
1 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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