At the end of Q2 the outlook darkened for global stock markets as the focus switched to the end of QE3, the Federal Reserve’s enormous stimulus programme. Speculation about the end of QE coincided with declines in the major indices, including the Dow Jones and S&P 500 in the US, which backed away from record highs, and steep rises in Treasury yields.
As we move towards a new quarter there are a few unanswered questions: how deep will the selloff be? Has the uptrend that began in 2012 come to an end? To answer these questions we need to look at three things: 1, the fundamental backdrop for stock markets, 2, the outlook for corporate earnings and 3, the technical picture for stocks.
As we mentioned above, the end of QE from the Federal Reserve is a major event risk for stock markets. Equity markets tend to move higher when central banks adopt loose monetary policies and QE3 was ultra-loose. Uncertainty about the timing of the end of QE3 may continue to weigh on stock markets at the beginning of this quarter as investors search for clues from Fed speakers and economic data about when QE may end. However, as we progress through this quarter we believe that ideas of a quick end to QE3 could be put to bed. While QE has to end at some point, in our view it will be a very slow process.
The Bloomberg surprise index measures analyst expectations with published economic data releases and creates a z-score, which represents the number of standard deviations that analyst expectations lie above or below normal surprise levels. As you can see below, in early June analysts had over-estimated economic data, and so the surprise index was in negative territory. There are a couple of things to point out: the negative surprises were not as deep as they were in mid-2011 and mid-2012, which suggests that the summer slowdown may not be as severe this year, however, economic data also did not surprise as much on the upside in early 2013. A moderate economic performance supports a cautious approach to ending QE3 from the Fed, which could protect stocks from a sharp sell-off in the third quarter.
Figure 8: Bloomberg economic surprise index
Source: Bloomberg, FOREX.com
Corporate profits in the US are also a concern. In Q1 2013 corporate profits started to slow. The headline measure of corporate profit (with inventory valuation and capital consumption adjustments) decreased by more than $40 billion in contrast to an increase of $45.4 billion in Q4 2012, according to the Bureau of Economic Analysis (BEA). There were declines in both financial and non-financial corporations, and this drop in profits also reduced the amount of corporate tax flowing into the government’s coffers. Although this data is released with a lag it is still significant. Has the corporate profit cycle turned? If we have reached a peak in corporate profits then it could be even harder for markets to rally. The end of QE3 could mean that investors start to scrutinise corporate balance sheets much more closely than they have been doing in recent quarters, and they may not like what they see. Added to this, analysts expect a healthy 8.5% increase in earnings per share in 2013, but estimates may have to be revised lower. This may add to the downward pressure on stock markets in Q3.
Figure 9: US corporate profits ($bn)
Source: Bloomberg, FOREX.com
The technical picture for equity markets is not clear cut this quarter. The Nikkei had led global stock markets lower since early June when it fell below a key support level at 13,700, its 50-day moving average, which was a bearish development for this index. European and US stock markets have not fared as badly as the Nikkei and were still managing to stay above key support levels at the time of writing. However, the markets seem fairly sticky around key resistance zones including: 8,500 in the German Dax, 6,800 in the FTSE 100, 15,500 in the Dow Jones and 1,700 in the S&P 500. Right now the declines in global equity markets look like a healthy pullback and do not suggest that the global stock market uptrend is over just yet. However, watch out for any further breakouts to the downside that could see steeper declines in the S&P 500 towards 1,560 then 1,490 – the 100 and 200-day smas. Below these levels would jeopardise current uptrends in markets and may suggest further losses are on the cards. Overall, we could see markets range trading this quarter, however the caveat is that either economic data deteriorates sharply in the US or QE3 comes to an end sooner than we think. If these scenarios play out then we could see a much sharper decline in global markets.