Will the US-led recovery in global equity markets last? - Capital Economics

Analysts at Capital Economics explained that the US initially led the recovery in stock markets around the world from their falls of a few weeks ago. But the S&P 500 faltered a bit earlier this week, and we doubt that it will drive global equities higher again in the coming quarters.

Key Quotes:

"The strength of the recent rebound in US equities may have been partly just a reflection of the fact that they fell further in the first place. Indeed, they have typically done no better than those in other developed markets since equities first started to slide in late January.

The relative performance of US equities in local currency terms has also been flattered by the renewed weakness of the dollar since they started to recover. The strength of the yen, in particular, has held Japan’s stock market back, at least until the past couple of days.

The US stock market has also benefitted since it began to bounce back from its much greater weighting towards IT firms. The IT sector has been the top performer across developed markets since 8th February, having fallen particularly far before that. It accounts for nearly 25% of the US stock market, compared to just over 10% on average for other developed markets. 

In our view, the recovery in the US stock market is likely to unwind. For a start, we don’t think that the dollar will fall further this year. And we don’t expect another rally in the shares of IT firms.

More generally, we project that the increase in wage inflation which spooked investors early this month has further to run given the tightness of the US labour market. We think that inflation more generally will rise this year too.

Admittedly, we doubt that this will result in a lot more Fed tightening than is now discounted in markets, or a large increase in Treasury yields. But it might be enough to maintain the pressure on equities. Meanwhile, higher wages would also eat into profit margins. Our end-2018 forecast for the S&P 500 is therefore 2,600, below its current level of about 2,730.

What’s more, we think that the cumulative effects of Fed tightening will eventually take a toll on the US economy, particularly once the effects of fiscal stimulus start to fade. We suspect that this will cause the S&P 500 to fall quite sharply, and our forecast for the index for the end of next year is 2,300.

Although we expect other advanced economies to remain healthy, we doubt that their equities will prove resilient. As we pointed out before the correction in January and February, they have nearly always slumped when the US stock market has fallen sharply, even when the reason for the decline in the US has had little to do with the rest of the world.

We think that the dollar’s slide will resume in 2019 too, which would also weigh on the relative performance of equities outside the US."