Do Markets Crash when Economies Improve?
By Ahmed Shams El Din
A downside of being a financial analyst these days is that you may find yourself called upon to explain why solid economic reports may cause a severe markets sell-off. Strong wage growth and employment data in the US have shaken global markets on concerns that the US economy may be overheated, and that stronger-than-expected inflation could lead to a more aggressive series of rate hikes; hence, sovereign yields surged, and stock valuations suddenly looked expensive! The world’s major indices have dipped severely by 4-5% yesterday (S&P -4.1%, DJ -4.6%, Nikki -4.73%..etc). Ironically, however, is how markets sentiment have changed within a couple of months, from skepticism over recovery as inflation had persistently disappointed, to the extreme talks about recession as the US economy may have become overheated.
One of the fundamental concepts we used to teach junior analysts is that one should never argue against the investors’ collective choice of market risk premium (k), but rather focus on the earnings quality (e) and growth (g). Perhaps, we should add a disclaimer to this; “assuming Quant models and automated trades are on our side”. The proliferation of automatic trading models and the rise in their share of daily trading have become major contributors to markets’ volatility and short-term behavior, in my view, and this could have exacerbated the magnitude of markets’ rout recently.
Having said that, I wish I could sit back and urge you not to panic as fundamentals are, at least, better than any other time since the outbreak of the GFC, but the current environment indeed helps the market bears’ rhetoric on a recession that would end some of the longest economic expansions in the history of capital markets, building on i) the length of historical expansion cycles; and ii) the shape of the yield curve (inverse yield curve has historically been a reliable predictor of recessions).
But honestly, this assumes that the post-crisis era has followed the standard economic models seen during previous cycles and ignores the impact of extraordinary fiscal and monetary measures taken in the past decade, the normalisation of which will require so much time and pain for the markets to stabilise. Risks to global recovery, in fact, have been largely unchanged over the past decade; the painful economic rebalancing in China, soaring emerging markets debt and disharmonised policies in the EU. While none of these risks have worsened recently, their price did. Essentially, our best guess is that the current market rout is driven by a repricing of risk across all the asset classes, as bonds yields have surged. While this could increase trading volatility significantly, it should not dismantle the recent good economic news. At the end of the day, the spread of US 10-year and two-year treasury bonds, while historically low, remains well above the levels seen right before the last three market crises, and this seems to be supported by the analysis of market equity risk premiums.
Back to basics: What ERP is the market using today?
If earnings quality is better than before and assuming growth expectations remain intact, estimating the market’s implied risk premium today vs. historical cycles would give us some guidance on how low the markets could go in a no-recession scenario. Back to basics, the forward P/E is essentially the intrinsic value of stocks adjusted for growth (1 / Rf +Rp – g, where Rf is the risk free rate, Rp is the risk premium and g is growth). Hypothetically, therefore, earnings yield (E/P) would be equal to Rf + R – g; hence, we have derived the implied market risk premium on this basis (Rp = E/P – Rf + g).
This exercise implies a risk free rate of 4.6%, if we factor in trailing market P/E historically (5.92%on a 12M fwd P/E), which is less than one standard deviation below the 10-year average (post-crisis era), but well above the market’s 20-year average and historical long-term average (1990-2018).
Assuming ERP on par with the post-crisis levels and a 150bps hike in interest rates in the next 12 to 18 months and 2.5% normalized growth, this would still leave the S&P500’s P/E at 14-15x range, some 7-8% downside from here; hence, hypothetically, one would buy the dips if the current sell-off continues further.
Strong dollar inevitable; headwinds for commodities and EM
If I would highlight any high-conviction idea amidst the current global uncertainties, it would be a strong rebound in the USD index, particularly after unjustifiably losing some 15% from its last peak in early 2017. This represents a strong headwind for commodity prices, which -besides a strong dollar and rising interest rates- does not bode well for emerging markets in general. But the focus will remain skewed towards country specific factors such as Egypt (reform program) and Kuwait (markets status upgrade)…
Ahmed Shams El Din is an Egyptian finance professional, finance professor, writer and speaker. Currently, Shams El Din is a Managing Director, Global Head of Research and a member of the IB Management Committee at EFG Hermes, the largest investment bank in the Middle East and North Africa (MENA) region. He is also an adjunct Faculty of Management, the American University in Cairo (AUC), where he teaches finance and investments for undergraduates and “value creation” and “corporate valuation” for MBAs and Master of Corporate Finance (MCF) students.