Animal spirits have returned to equity markets. The S&P 500 ended the day less than half a percent away from its January record high. Meanwhile, the VIX index of implied US equity volatility has fallen to its lowest level since January, to 10.8 – well below its 200-day moving average of 13.3.
There are certainly grounds for optimism. More than three-quarters of S&P 500 firms are beating earnings forecasts, setting the index on track for growth of over 25%.
But investors should beware of over exuberance:
- Trade tensions continue to intensify. China recently pledged to impose higher tariffs on USD 60bn worth of US goods if the US follows through on a threat to scale up taxes on USD 200bn of imports from 10% to 25%. A higher tariff from the US could have a disproportionately negative economic impact, disrupting supply chains, and could drag US GDP growth below 1% in the final quarter of this year.
- Global central banks are withdrawing net liquidity this month for the first time since 2009. This reflects balance-sheet reduction from the Federal Reserve and a tapering of bond purchases by the European Central Bank.
- Eurozone earnings have been letting the side down. Earnings for the region are on track to grow by just a fifth as much as their US counterparts, at 5%.
Excluding energy firms, the outcome could be as low as 2%.
So, while investors should remain invested over a strategic time horizon, we believe risks are not fully priced into the market. As a result, we prefer to stay broadly neutral on risk over a six-month horizon.
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