Will drought period for capital growth kill equity bulls

Stockmarkets may be shifting sideways, but there are plenty of potential catalysts for a move either way. Analyst Edmond Jackson discusses what to watch for this summer.

High summer, and a cocktail of trade tensions and Brexit scare stories is starting to trickle into company updates; yet there are no real jitters among investors while equity dividends yields are the go-to asset for investment income as interest rates edge up only tentatively.  

Unless Italy's new government drops the tray in September, in a stand-off versus EU institutions, there's not enough to disrupt the party like in summer 2011.  But after nearly a decade of strong equity returns, spirited by monetary expansion, bulls are staring at increasingly parched ground in terms of new drivers for capital growth.

What next for US earnings after 20% Q2 growth?

US stocks have trended higher in July, maintaining a volatile uptrend and putting the S&P 500 index back near the top of a 2,581 to 2,871 range, after February's sell-off.  Mind how Netflix Inc and Amazon.com Inc have been key drivers, otherwise US stocks are mixed with six of the S&P 500's 11 sectors now in negative territory this year:  telecoms, consumer staples and financials faring worst, IT and consumer discretionary spending best, both up about 15%. 

Bears may question if the business cycle is finally peaking, while bulls take heart, the index's historic price/earnings (PE) multiple of 16 times is now in line with its five-year average.  Quite whether that was partly artificial anyway after stocks were boosted by Fed stimulus.

Latest reporting has seen most companies beat Q2 2018 expectations with strong performance at both top and bottom lines – earnings in particular are up about 20% like-for-like, although they have benefited from tax cuts and share buybacks.  

So, the ongoing growth rate is in question as trade conflicts start to hurt: e.g. Boeing Co and General Motors Co disappointing with their updates, partly due to higher raw material costs following US tariffs on steel and aluminium.  More positively Coca-Cola Co, a bellwether Warren Buffett stock, has outperformed revenue expectations, also United Parcel Service Inc Class B, both reflecting recently strong consumer confidence.

Risks in technology and housing

Yet the FANGs – Facebook Inc A, Amazon, Netflix and Alphabet Inc A – which have powered most of the stockmarket's recent advances, are suddenly in question.  Netflix disappointed mid-July after failing to meet its own subscriber projections, and Facebook now warned its revenue growth will decline from over 40% later this year.  

While this follows exposure of the ways Facebook has exploited members' data, it could affect both user-confidence and investor sentiment towards other tech-companies reliant on people spending time on digital devices.  There's also a concern, tech margins are peaking if regulators and politicians see them as deserving a reign back by way of restrictions and taxes.

Meanwhile, on the US macro front, and contradicting positive signs for consumer spending, US home sales fell unexpectedly in June, reflecting a shortage of those affordable and rising prices continuing to limit demand.  

New-builds have plunged to a nine-month low and mortgages are reducing.  Some would say this is a bearish sign for the wider US economy and is mirrored for example by a jump in UK estate agency insolvencies, where a fifth of firms are estimated at risk of going bust amid sluggish sales.  

But here it's also a healthy sign: high streets having become oversupplied with estate agents’ offices, whereas the post-Brexit economy should restructure towards manufacturing and export sales, rather than skimming over-priced homes (after years of monetary stimulus) for transaction fees. 

So, it’s a mixed overture of news where the US is apt to set the tone globally.  Not enough to genuinely upset equity demand as yet, but it warrants wary attention.

President Trump's unpredictability on trade policy

Trump's latest meeting with EC President Juncker has been a remarkable turnaround from the belligerence of recent weeks, now agreeing to work towards zero tariffs, barriers and subsidies. 

It's hardly surprising to long-term followers of Trump's business negotiations: commencing with bluster and heavy demands, then moving to a settlement enabling his opposite side to feel they have come off comparatively well.  Although this apparent US/EU climb-down does look as if rather desperate pressure was applied from business and diplomatic circles to instill common sense before any further damage is done.  

Time will tell once negotiations get underway whether this really is a concord or another twist in Trump's mercurial record.  A current positive is it showing the US Administration recognises need, not to let trade conflict spiral out of control.  

If progress can be made in talks – implying the US’s recent tough stance on tariffs has been a negotiating ploy – it could help lift storm clouds gathered over equities, according to what exactly is the follow-through and whether it creates precedent for China.  That's still a big ask, and although the EU has agreed to buy soya beans and natural gas, the EU may not agree a major revision of trade terms without a US climb-down on steel and aluminium tariffs. 

 Smouldering debt issues to break into wild-fires?

Italy is a situation to watch, its two ruling populist parties seemingly on a collision course with the EU this September, with ambitious fiscal plans for a universal basic income potentially being sanctioned by the European Commission, the worst-case scenario as Italy also leaving the eurozone. 

The dynamics are hard to anticipate: while Greece ended up over-ruled, Italy’s debt is roughly 10 times bigger thus creating risks for the EU's heavy-handed approach.  

But Italy's coalition is in a hard place also, with polls showing 60-72% of Italians preferring to stay in the euro, partly to guarantee their savings versus the alternative of a devalued new lira.  Thus, scope for brinkmanship may be checked both for Brussels and Rome, despite their looking on course for friction and some extent of fire come September when Italy’s budget is presented.  

Brussels appears to reckon the Italian government will change course from expanding its budget deficit, to avoid catastrophe, while Rome figures Italy is too big to fail and has enough voters behind it.  

Obviously, the precedent is Greece blinking first during its financial crisis, unable to accept the risks of life outside the euro.  So, mind all this can potentially to disturb markets as it comes to a head.

Another aspect of debt risk, albeit less-followed, is the effect of rising US interest rates on corporate bonds after US firms have increased debt for acquisitions and buybacks while service costs have been low.  

A risk to watch for is widening credit spreads versus government bonds, with bond investors demanding a higher return for the risks if the US economy slows.  Thus, fire could break out in debt markets before (affecting) equities, a classic late-cycle risk as interest rates rise.

Dividends mainly secure, but where's the upside?

The broad picture is UK corporate newsflow pretty much in line with expectations, with a few warnings, and I'd mind how hotels group Millennium & Copthorne Hotels has just done so - its London hotels under revenue and cost pressures - hotels being a classic cyclical indicator.  

For the foreseeable future, dividends look mainly secure and at this stage in the cycle I'm inclined to favour well-established firms whose strength of yield should help support their equity.  

If economic/company news turns tougher in the months ahead, however, capital growth will get more challenging and protection become first priority.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.