End of the US equity bull market or merely a correction?

Today's news headlines:

  • ‘UK and Brussels close to agreeing Brexit deal’. Prime Minister Theresa May gathers her inner circle while Eurosceptics push back on ‘temporary’ customs union plan. (Financial Times)
  • ‘US Treasury staff said to find China isn’t manipulating Yuan’. The finding could avert escalation of a US-China trade war. (Bloomberg)
  • ‘Italian lawmakers approve deficit goal as EU showdown nears’. Populist leaders say they won’t back down from spending plans. (Bloomberg)
  • ‘Asian shares bounce after rout, but sentiment fragile’. Asian shares found a slightly firmer footing on Friday to set course for their first gain in two weeks. (Reuters)
  • ‘IMF warns trade friction, market turmoil to hurt Asian growth’. Sustained trade tensions could slash Asia’s economic growth by up to 0.9% in coming years, the International Monetary Fund said, urging policymakers in the region to liberalise markets to offset the fall in export sales. (Reuters)

In this morning’s Asian trading, the global stock market sell-off showed signs of abating. The Nikkei 225 spent the session retracing losses on the open and is currently down only 0.1%. Hong Kong’s Hang Seng index traded higher by 2.0% on the day and China’s Shanghai Composite has gained 1.88%. Early futures trading also indicates a more positive open for European and US equities today. The more positive trading environment this morning follows heavy equity losses in Thursday’s US session. The S&P tumbled 2.1% and the global FTSE ALL-World Index retreated for a sixth day running, erasing all of 2018’s gains.

It is certainly too early to sound the all clear. The more positive equity environment this morning could be traders taking a breather before the start of US earnings season today. It could also be due to the lower US 10-year yield—higher US yields were the proximate cause of the equity sell-off in the first place. The irony of financial markets is that a crisis sparked by a sell-off in US Treasuries can cause investors to flood back into the apparent safety of these US bonds in order to escape the consequential carnage in equity markets. Could the problem have resulted in its own solution?

Our take remains that this is an equity market correction and not the end of the bull run. Firstly, bull markets are ended by recessions, and there is certainly no current sign of a recession in the US. Secondly, we believe Federal Reserve rate increases in future will be slow and end by mid-2019 at the latest. This should limit the rises in the US 10-year yield. Yesterday’s US inflation miss reinforces our view that a stronger Dollar is depressing US import prices, keeping a lid on US inflation. While the headline miss was due to energy price falls, food prices were flat on the month and clothing prices declined on an annual basis. Imported consumer goods prices are restrained by a stronger Dollar and limits the Fed’s need to raise rates aggressively.

Thirdly, the Fed will take the recent market volatility as a warning. Tighten too fast or too aggressively and the central bank risks reversing the benefits of the quantitative easing they implemented after 2008 when the Global Financial Crisis was in full swing.

For near-term direction, JP Morgan and Citigroup earning reports due out today will be key to stabilising or aggravating the sell-off. The critical issue is that with US 10-year yields around the 3.2% level, equities need to justify their lofty valuations. Strong earnings reports could help to stabilise the sell-off further.

The currency market continues to take its cue from the equity space. The Dollar is showing a closer correlation to equity markets than to yields of late and was down 0.4% yesterday, in trade-weighted terms. Safe-haven currencies were granted some reprieve yesterday, following substantial gains in other sessions. The Swiss Franc was broadly flat against the Dollar while the Japanese Yen gained 0.09%. All other G10 currencies were higher against the Dollar with the commodity complex the biggest winners. The stronger performance for the Australian Dollar and New Zealand Dollar was on the back of better metals prices. The softer Dollar, equity market sell-off and a break higher in gold helped lift the metals complex.

For the day ahead, the Eurozone’s August Industrial Production reading will be released in the morning session. In the afternoon, the usually overlooked US Import and Export Price indices take on increased importance due to trade tariffs and a stronger USD depressing import prices. Import prices have declined month-on-month for the last three months as the deflationary effect of a strong Dollar offsets higher trade tariffs. The October release of the University of Michigan’s Consumer Sentiment index provides an important insight into US households. In September, the index topped 100.0 for only the third time since January 2004. Interestingly, the increase was driven by consumers within the lower third of the income distribution. As US President Donald’s Trump traditional political base, this could suggest an out-turn in his favour at the US mid-terms.

On the speakers’ calendar for the day ahead, two Federal Reserve doves feature. Charles Evans takes part in a discussion at an investment conference while Raphael Bostic discusses economics later in the session.