Recent economic data have been strong across the world boosted by China reopening from covid, falling gas prices in Europe and strong numbers for employment and consumer spending in the US. This has all but removed fears of imminent recession. Stronger economies should mean better earnings for companies and higher stock prices, but February is shaping up to be a weak month for US equities and emerging markets have fared even worse with the MSCI index underperforming by close to 9% since its relative peak in mid January.
So what’s going on?
The answer is twofold: first stronger US data means more tightening by the Federal Reserve and higher interest rates are bad for equities. Moreover, the read across from a stronger economy to stronger earnings may be working at present but the super tight labour market means margins are under pressure. Almost all of the S&P500 have reported their results for the final quarter of 2022 and despite revenue growth of close to 6% on a year ago, earnings are down 4%. There’s been a big squeeze on margins.
We’ve also had bad news on US inflation which has dented hopes that falling prices for commodities and easing of supply constraints on goods would lead to a virtuous circle of disinflation so that the Fed could get back towards its 2% target without a recession. That scenario is still a possible, but my guess is that a recession in the US has merely been postponed.
Economic numbers have been mixed in Europe with the latest GDP figures for Germany contracting in Q4 2022 with some big declines in discretionary consumer spending. That’s backward looking but the future looks much brighter because of the decline in natural gas prices. Consumer and business confidence has improved, and budget deficits are also looking healthier: Germany allocated €200bn to its energy price support scheme. That’s a massive 5% of GDP and it now looks like they’ll only need a fraction of that.
There’s been a truly remarkable improvement in the UK too. Consumer confidence over the winter slumped to levels weaker than anything seen in the worst of the covid pandemic and worse than in the Global financial Crisis. The latest figures show a strong bounce and I expect further improvements after next month’s Budget. I believe the planned increases in household energy bills and fuel duty will be scrapped when the Office Budget Responsibility redo their forecasts. The Bank of England should also make a similar cut to their inflation forecasts as a result of the Budget changes. The BoE’s projections already had a sharp fall in inflation factored in for 2024 but that was because they expected a recession in 2023. That recession now seems unlikely and the dark days following Kwasi Kwarteng’s budget are a distant memory.
Before we get too carried away, we’re not looking at an economic boom. Energy prices will still be higher than they were before Russia invaded Ukraine and higher interest rates will also restrain the economy, especially in the UK via the housing market. Nevertheless, the outlook overall has improved quite dramatically.
What does all this mean for equities? Unlike the US, companies in Europe are not suffering the same margin squeeze. Indeed their Q4 earnings have beaten those in the US handsomely. Yes, the European Central Bank and Bank of Europe will have to raise interest rates further to control inflation but the demand destruction that we expected from soaring energy prices has receded. We expect European equities to outperform the US this year. And if the US economy does start to weaken, that should take some of the pressure off bond yields and weaken the US dollar. That would help emerging market equities.