Weekly Winzer: Optimistic profit expectations despite risks

In euro terms, the performance of the broad equity market has been negative since the beginning of the year. However, the environment has shown an improving trend since the second week of April. From a market perspective, a de-escalation in the US trade conflict has become more likely since then.

With the recent announcements of higher tariffs by US President Donald Trump, a negotiated solution looks likely to be that the trading partners accept the prescribed tariffs by and large and do not respond with significant counter-tariffs. However, China is an important stumbling block here. In contrast to other countries, the People’s Republic is much less receptive to external pressure. The 90-day deadline for negotiations expires in mid-August.

Analysts vs. economists

Share prices are rising and credit risk premiums are falling to low levels, as is equity volatility. Even the (trade-weighted) US dollar has strengthened slightly since the beginning of July after months of weakening and the gold price in US dollars is moving sideways (at a high level).

The estimates for corporate earnings growth also support this market trend. In addition to market participants, equity analysts are also optimistic. How does this fit in with the descriptions of economists and political analysts, who are talking about economic risks for the US (higher inflation, lower growth) and a change in the world order?

There are several explanations for the positive market trend:

• The global economy and the financial market have weathered the crises of recent years surprisingly well. However, this resilience can be attributed primarily to fiscal and monetary policy. The response to crises has always been an – in some cases considerable – expansion of the budget deficit, which was de facto financed by the central banks. Both debt levels and new borrowing are now high. From a long-term perspective, the public debt dynamics in many countries are not sustainable. At the same time, central banks are finding it more difficult than before to lower key interest rates, as the inflation target of 2% has not been reached. This applies in particular to the US Federal Reserve. It is becoming increasingly difficult for monetary and fiscal policy to provide additional stimulus.

• Some commentators have observed that President Trump tones down announcements as soon as the market reaction is strongly negative. The last time this happened was at the beginning of April, when the threat of a global trade war raised fears of a global economic crisis. However, the assessment that things will not be as bad as feared is not based on a stable foundation.

• The potential negative impact of US policy is not yet (or not strongly) visible in the published data. Market participants are trying to anticipate, but central banks are also using a backward-looking, data-dependent approach in view of the difficulty of forecasting. Only in the medium term could there be negative developments.

• The financial environment is positive despite negative news from the White House. This circular reasoning (the markets are rising because they are rising) is not helpful, but is nevertheless sometimes used as a justification.

• In fact, US policy is extremely unorthodox in several respects. These include broad-based tariff increases, a high budget deficit and pressure on the central bank and universities. The combination of a high current account deficit (around 4% of GDP), a high budget deficit (around 6.5% of GDP) and potentially sharp interest rate cuts (several percentage points are being called for by the US President) would likely exert strong downward pressure on the US dollar.
  
  The indications that financial repression measures are also being considered (e.g. converting government bonds into perpetual bonds) are used as additional arguments for a long-term weakening of the US dollar. The immediate effects of US policy on economic growth tend to be inflationary in net terms (interest rate cuts, US dollar weakening and a high budget deficit support growth and inflation). All other things being equal, higher growth means higher corporate sales and higher corporate profits (positive for equities). However, governance is more akin to that of a poorly managed emerging market. Normally, the guardians of the sustainability of economic and fiscal policy are the bond markets (bond vigilantes). In the absence of a Liz Truss moment (alluding to the British Prime Minister’s short tenure in office in the context of a loss of confidence in the financial markets), there is no incentive for US policy to change (see TACO, “Trump always chickens out”). For example, in early July, President Trump commented on the new US tariff measures with regard to the financial markets, saying that they had been well received.

 

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