With economies weakening further near term and monetary policies on hold, will equities continue to suffer?
The outlook for equities hinges on how near we are to a trough in the economic cycle. Historical evidence suggests the best time to buy is six months before the low in global industrial output growth (table below). The previous 12 months usually sees losses, while waiting for the trough risks missing out on the upside. As explained, I think growth will start to recover by year-end, which implies equities should recover.
Assuming a later trough, how much more could they fall?
Valuations seem supportive. The world earnings yield is currently 7%, which is the highest since 1985 (first chart). However, this is misleading because earnings are above trend and are likely to fall significantly. Adjusting earnings for the cycle, the yield is about 5 ¾%, which is still well above the long-term average of 5%. The 2003 stock market bottom occurred at a yield of 6%, which would imply a further 5% fall in markets.
The dollar has been performing a bit better lately. Is this the beginning of a major turnaround?
The dollar may have bottomed but a rise in US interest rates is likely to be required for a major recovery. The dollar is certainly cheap, particularly against European currencies. And the US trade position has been improving, both in absolute terms and relative to trends elsewhere (second chart). However, the low level of US interest rates is a big obstacle to a recovery. US short rates are currently more than 2% lower than Eurozone rates, which is the mirror-image of the late 1990s, when they were over 2% higher (third chart). The dollar was then strong and only started to fall significantly after the rate gap closed. Similarly, it may take a convergence of US and Eurozone rates now before the dollar embarks on a sustained uptrend.
