Following a strong rally in stock markets in February and early March, we are increasingly concerned that we are in for more of the correction that started over the past week. A negative mix of factors is keeping risk assets vulnerable in the short term.
1. All regions except Europe are slowing. US data continued to be soft over the past week as the retail sales report for February saw downward revisions and points to the weakest consumer spending over the past four months since 2009 (see Flash Comment: US retail sales report disappoint again – not all about weather, 14 March 2014). While some of the weakness is clearly due to the bad weather, we also believe that a slowdown in housing and a rise in gasoline prices are short-term headwinds causing some genuine slowing. The second largest economy in the world – China – is also still in a slowdown phase. This became clear earlier this week with the release of weak industrial production and retail sales figures (see Flash Comment: China – weak data suggests GDP growth could drop below government’s 7.5% growth target as soon as Q1, from 13 March 2014). Japan has also witnessed somewhat weaker PMI and GDP data recently and our models suggest that growth is bound to slow during the spring and summer as the VAT hike in April is also going to weigh on the economy. For an overview of developments in global leading indicators, see our Global Business Cycle Monitor released earlier this week.
2. Tensions are rising with the Russia/Ukraine crisis. On Sunday, a referendum will be held in Crimea on whether the peninsula should rejoin Russia and it seems likely that the vote will be in favour of becoming part of Russia. This could escalate the situation significantly. Adding to the worries are reports that Russia massed troops and armoured vehicles in at least three regions along Ukraine’s eastern border. This was met with an unusually sharp rhetoric from German Chancellor Angela Merkel, who warned that Russia must abandon what she called the politics of the 19th and 20th centuries or face diplomatic and economic retaliation from a united Europe.
3. US stock markets have been remarkably resilient so far leaving valuation more stretched. Despite the bad data and geopolitical tensions, the US market reached new highs last week taking the P/E ratio on S&P500 to around 17 – the highest level since 2004. Euro stocks have seen more of a correction and next week will be an important test of sentiment as prices are at technical support levels.
4. Earnings growth likely to disappoint again in Q1. While markets have been forgiving on soft earnings growth in Q4, this was partly based on an expectation that Q1 would be the quarter where things would start to move. Given the weak global growth in Q1, we are unlikely to see this rebound in earnings. Given the above factors, it makes markets more vulnerable and less forgiving this time.
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