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Which way is the wind blowing this week?
The seemingly unstoppable rise in equity prices hit a bit of a speed bump this Thursday with the release of the US CPI report for the month of September. The data showed that the downward progress on inflation stalled, with core inflation rising by 0.3%, the same rate as in August, and slightly above market expectations of an increase of 0.2%. Annual core inflation rose from the August read of 3.2% to 3.3%, against market expectations of a stable rate of 3.2%. Big deal, you might reasonably respond, but this small miss in expected inflation rates for September was enough to stop the equity rally that has been playing out across global markets for over 2 months now, if only momentarily.
So, what has been driving markets? To begin, following the scare earlier this year between February and April when the downward trend in core inflation seemed to stall, successive declines in inflation, including an outsized fall in July, prompted the US Federal Reserve (Fed) to prep the market for the start of the US easing cycle. The impact was felt across bond markets and the subsequent fall in interest rates boosted the outlook for risk assets, including equities, and the global rally was underway.
The equity rally was momentarily disrupted in early August and again in early September by a couple of weak US employment reports. However, with the Fed shifting their focus from inflation risks to risks of missing its full-employment mandate, the Fed delivered a 50bp cut in mid-September. Equity markets were once again off to the races, with the market pricing in a further 200bps of rate cuts over the next 18 months. A further boost to equities has been delivered by the US economy, as it continues to show signs of exceptionalism (the Atlanta Fed Nowcast for US economic activity is tracking an annualised growth rate of 3.2% for September quarter, around 1.5 percentage point higher than trend growth) and by promising signs of support by Chinese authorities for the flagging China economy. Even a surprisingly strong US employment report last week, which led the market to take out two rate cuts from its profile, could not stall the march higher in equity markets given the increased likelihood of a soft-landing in the US economy.
But, as we saw this week, the threat of a stall in progress on inflation is still hovering in the background. Of course, risks are present, as they always are, both to the upside and downside in terms of inflation and growth. Currently, we feel those risks are balanced. Furthermore, the slight upward surprise in core inflation during September was much smaller than we saw earlier in the year, and with promising trends emerging around housing inflation, our view is that core inflation remains on-track to fall close to target by the end of next year.
However, there is one risk that is increasingly skewed to the downside, and that is the risk posed by equity valuations. As they become increasingly stretched, the equity market becomes susceptible to small misses in expectations, be they on inflation, economic growth or the trajectory of monetary policy. What can we say about equity valuations now?
In the US, the world’s largest market, simple metrics, such as price/earnings (PE) multiples are elevated, indicating substantial overvaluation at current prices. For example, the PE multiple for the S&P 500 is currently at a level of around 22, compared to its long run average of around 16, based on IBES 1-year forward earnings expectations. This is more than one standard deviation above the long run average, typically a sign of significant overvaluation.
Adding to concerns is that this elevated multiple is based on expectations of a 14% increase in company earnings over the coming twelve months. This is more than double the long run trend rate of growth in earnings and almost double the pace of earnings growth over the last twelve months which occurred during an exceptional run of above trend US economic activity. Although the US economy continues to perform strongly, and in our view is that it is some distance from recession, the current pace of economic growth is not sustainable and is likely to pull back to a more trend-like growth rate over 2025. This casts doubt on the prospect of S&P 500 companies achieving the anticipated 14% growth in earnings that are currently underpinning equity valuations, notwithstanding the current exuberance surrounding AI technology. Hence, the possibility of earnings disappointments over the coming twelve months poses a significant downside risk to the US equity market. The Australian market also appears overvalued based on current PE multiples. However, earnings expectations in Australia are nowhere near as optimistic as in the US, and less susceptible to downside surprise.
Despite the overvaluation signals, we are not anticipating an imminent collapse in global equity markets. The reasons are twofold. First, the US and global economies are on a path towards a soft-landing, meaning that the risk of forced asset sales that usually accompany recessions and lead to sudden and sharp equity market corrections is unlikely. Second, central banks have ample scope to cut rates if recession risk increases.
The biggest risk to the outlook is a disruption to the downtrend in inflation, leading central banks to stall their easing cycle, or even raise rates. If the reversal in inflation is a product of stronger economic activity, the impact of higher rates will be partially offset by strong company earnings growth and any correction in equity prices is likely to be orderly. Rather, the risk of a disorderly correction in equity markets is from inflation that is driven by supply-side shocks (such as higher commodity prices or tariffs) that induce weaker (rather than stronger) economic growth; i.e., the risk of stagflation. Here central banks will again face the conundrum of whether to wait for the supply-side shock(s) to subside and resist tightening policy, with the risk of losing control of inflation expectations; or whether to raise rates to target inflation but risk driving the economy into recession and creating a rout in equity markets. While the stagflation risk is present, it is not our central case, with a current probability of around 13% of materialising.