Article written by LGT Crestone Head of Public Markets Todd Hoare. Published in The Australian Financial Review Tuesday September 10, 2024.
Returns have been dominated by a handful of companies but that scenario is unlikely to persist.
As recent falls demonstrate, we live in a world of constant volatility. Global equities were, until recently, unchanged from their July 17 highs, masking what has actually been a turbulent period for global markets.
The S&P 500 suffered its largest drawdown – almost 10 per cent – over the period from July 17 to August 5.
The volatility index, or VIX, experienced its largest spike since the pandemic, and its second-largest one-day spike in history. More impressively, it has also seen its fastest “return to calm”, with the quickest retracement of a 25-point spike in history.
There were several catalysts for the increased volatility, and at times, panic, but as is so often the case, it began and ended with corporate profitability. The S&P 500 was in the middle of its best stretch without a decline of at least 2 per cent since the start of the global financial crisis in 2007 – 356 trading days – before a tech-led sell-off on July 24 saw the index fall 2.3 per cent.
Tesla and Alphabet reported second-quarter earnings that were weaker than expected.
Macroeconomics then took centre stage a week later, with events on both sides of the Pacific being key. Firstly, a hawkish move by the Bank of Japan, to lift rates to 0.25 per cent versus expectations for a hold at 0.1 per cent, saw investors unwind so-called carry trades, upending global capital flows in currency markets.
Having already appreciated about 5 per cent in three weeks, the Japanese yen appreciated a further 6 per cent against the US dollar in just a matter of days, a startling move for one of the less volatile global currency pairs.
A few days later, US jobs data came in much weaker than expected, and at a sharp downward revision to the prior month. It’s also worth noting that the US Bureau of Labor Statistics revised down the number of workers on US payrolls by 818,000 over the 12 months to March 2024, the largest downward revision since 2009.
Alongside an increase in the unemployment rate to 4.3 per cent versus expectations for 4.1 per cent, this sparked concerns that the Federal Reserve may have erred in keeping rates at 5.5 per cent for the past 12 months, with fears of a US recession rising.
Since these events, however, global equities have staged a remarkable comeback. They are back within striking distance of all-time highs. Even Japan’s TOPIX, which went from all-time highs to bear market in less than a month, has recouped almost two-thirds of losses in just two weeks.
US second quarter earnings have proven resilient. S&P 500 earnings growth positively surprised, posting a 10.5 per cent gain year-on-year relative to expectations for 8.1 per cent on June 30. Although most of this is attributable to the magnificent seven, it should not be lost that the other 493 stocks are now positively contributing to earnings growth for the first time in six quarters.
So, what should sharemarket investors expect from here? Regardless of the direction of markets, investors should brace for an environment of more volatility.
Markets are no longer a one-way trade. Investors are now asked to analyse the odds of a weaker-than-expected economic slowdown, the timing and magnitude of Fed rate cuts, extended positioning in mega-cap tech (albeit one that is unwinding), a pending US election, conflicts around the globe, and a de-synchronised central bank monetary policy cycle.
Until recently, 2024 was an abnormally calm environment for global equity investors. For the year to July 23, there had only been three days when the MSCI World Index had fallen by more than 1 per cent.
This century, only 2017 had been “calmer”. Since then, the number of days when global equities have fallen by more than 1 per cent has more than doubled to seven days, and yet is still well below the average of 28 days.
Ultimately, corporate profitability remains the key arbiter for markets. On this front, there are divergences that suggest investors should brace for two-way volatility.
Bottom-up consensus 2025 estimates for S&P 500 earnings calls for +15 per cent growth, which looks a high hurdle in the context of still elevated interest rates (which act with a lag), record margins, and historical average earnings per share (EPS) growth rate of roughly half that. Rising unemployment often portends deteriorating EPS growth, rather than the acceleration that analysts are looking for.
Operating margins, already at record levels, are also expected to increase strongly over the next several years. Countering this, earnings outside the so-called magnificent seven are now growing, and although credit spreads have expanded, they remain contained.
Typically, some form of “shock” is a precondition for recessionary conditions and there is a school of thought that as investors and consumers have had some time to adjust to two years of hawkish Fed policy, a slower, incremental economic deceleration is mostly manageable vis-a-vis a more dramatic employment unwind. There is significant headroom for central banks to respond to the other side of their dual mandates – growth.
Rates markets are pricing in a Fed Funds rate of 3 per cent to 3.25 per cent by the end of 2025. If the Fed delivers that, and with credit “risk” signals muted and corporate balance sheets healthy, investors are likely to favour a “broadening” trade – that is, the narrow concentration of returns that have been dominated by just a handful of names is unlikely to persist.
Returns are likely to come from more constituents, by market capitalisation, region and style. To this end, it could mean investors favour an equally weighted version of the S&P 500, rather than its oft-quoted market cap equivalent, as well as Japanese equities, and smaller sized companies – first mid-caps and eventually small caps.
