WITH a seemingly unremitting diet of bad news over the past three months, it is remarkable how resilient share prices have been.
Nevertheless, poor monthly job creation data reported in America on Friday has sent a shiver down investors’ spines, with concerns rising that the upcoming US corporate earnings season may see the undermining of this key plank in the positive story for risk assets.
We would not be surprised to see a larger number of earnings shortfalls than in the first quarter.
In fact, given the challenges faced, including a spike in oil prices and supply chain disruptions caused by the Japanese tsunami, it would be remarkable if we did not.
It is also likely that many management teams will express caution about the clarity of the outlook for the rest of the year.
This is only prudent given the high level of political uncertainty introduced to businesses, both by the European leadership in failing to find a convincing administrative solution to the eurozone sovereign debt crisis and also by the American Congress in holding the financial system to ransom for political gain by refusing to raise the US debt ceiling in a timely manner.
Stock markets may initially have difficulty with this trend, since they have become accustomed to being positively surprised.
However, we would not expect a correction to turn into a rout for the following reasons.
Firstly, we see these results as reflecting the past.
As the summer comes to an end, we expect America’s recovery to regain momentum.
The effects of higher energy prices and Japanese supply chain disruptions have now largely worked through the system.
In the absence of further shocks from these sources or from political ineptitude in Europe or America, the well-capitalised corporate sector that is generating record profits and profitability should see risk appetites return.
There was strong evidence in the first quarter of significant capital expenditure increases – leading to employment growth (a resumption of a “self sustaining” economic growth cycle).
This link looks to have weakened in the second quarter due to the aforementioned temporary factors, but we do not think American corporations will have been scared back into a defensive mind set and expect to see better trends soon, with predatory M&A (in itself a stimulus to take risk for the tardy) a likely feature.
Secondly, the prospect of additional help from the Far East is becoming a realistic possibility. Japanese demand should become a positive force in the second half.
Additionally, the monetary tightening cycle in China is beginning to bite.
Although inflation is at about 6%, a fall in the indicators for industrial demand, a weakening in commodity prices and signs that speculative real estate prices are coming off the boil suggest that the tightening cycle may soon be over – removing the fear of a hard landing.
Finally, equity valuations are very attractive relative to risk-free assets.
Obviously, this assertion depends partly upon the level and rate of growth of earnings, but the point is that whilst corrections are not uncommon, bear markets usually start from more elevated valuation levels.
The exception is when they are hit by an unexpected shock.
Could the eurozone provide such a shock?
It could, but for now it looks as if it will be successful in deferring any day of reckoning – which should allow time for some sunshine to peek thorough the clouds of gloom.