Market consolidation after last week's correction

Equity markets recovered somewhat on Monday after last week’s fall out. In our opinion, the events of the past few days potentially indicate that the central banks of the US and UK will be wary before making any move to raise rates, and likewise will probably push the ECB closer to more aggressive measures. Citi, in a morning note, stated the view that the further set of sanctions on Russia will shave a few tenths off eurozone growth in 2014 and 2015. One would suggest that under normal circumstances this figure would make a minimal impact, but with Eurozone GDP growth anticipated to be approximately 1% for 2014, the effect is slightly more noteworthy. 

If we look at the potential threat to equity market stability, the geopolitical impact and Latin American defaults always have the potential to disrupt, but these are often only temporary. The performance of companies through earnings seasons is important, as that’s where the valuations come from. So far, at least for the 2nd quarter, consensus opinion amongst analysts is that there is enough to justify the current valuations. 

The bond market is the asset class we focus on for our lead to equity market performance. Last year we wrote on more than one occasion, as speculation developed that the Fed may be looking to wind down the bond purchase program, that the lead for equities was going to come from the bond market, and so it proved. Treasury yields rose sharply and the equity market dipped. The events of last week had no impact on the bond market; yields on US treasuries remained close to recent levels. Whilst one can pick up American equities that yield more than 10-year US treasuries and whilst the yields on equity markets of the UK and Europe remain above that of what 10-year bonds can offer, this should continue to support equity markets. 

Last week’s correction in the S&P 500 followed the largest weekly inflow into equity funds in 6 weeks. Analysts have suggested that the underperformance of high yield has been a lead indicator for equities, which were due a period of correction. Last week saw another $4.4bn of outflows from high yield funds. This is the third straight week of redemptions bringing the total in that period to $12bn. This outflow shows there has been some capitulation in high yield, and as default rates remain low, one would not be surprised to see high yield once again stabilise, this could well also add some stability to equities. 

According to Merrill Lynch, the current consensus is for a correction in the autumn and they believe that perhaps August may be a more likely period for equity markets to consolidate.

Posted on August 5, 2014 .