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Simon Wood: Cautious outlook for equities in the short-term

Equity markets face some short-term headwinds, such as the tapering of QE, but the longer-term outlook remains favourable.

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After market anxiety in early October over the US budget stand-off, a temporary agreement on the budget and debt ceiling was enough to avert a potential crisis. Markets duly rallied strongly for the remainder of the month. Following the Fed’s decision in September to hold off on the tapering of quantitative easing it was clear there had been plenty of pent-up demand for equities.

Progress from here might be harder going, however, if only because the market is somewhat overbought in the short term and one senses that a degree of profit taking would be healthy. That being said, it would not be unusual to see a seasonal rally up to the year-end, so maybe it will be the start of next year before we see a correction?

Certainly, the underlying economic fundamentals remain reasonably positive. In particular, the temporary US government shutdown and budget uncertainty do not seem to have significantly affected growth momentum. Meanwhile, the UK and European recoveries seem to be becoming more firmly established.

The latest Q3 reporting season in the UK has so far been a little lacklustre. It is not yet providing the degree of earnings upgrades momentum needed to drive the market sustainably higher, so this is another reason why the market might ” tread water” for a while.

The main risk on the horizon, however, is the somewhat ironic one of economic growth becoming more firmly established, which will therefore spark renewed fears of the imminent removal of monetary stimulus, particularly in the US.

Short-term traders could then worry that this will remove support for financial markets and be the precursor of genuinely tighter policy via higher interest rates. This is despite the fact that inflation is quiescent in all the leading developed economies, there is still plenty of spare capacity and no obvious  imbalances or overheating needing to be squashed.

Our own view is therefore more relaxed, for while the removal of QE is probable over the next 12 months, it does not follow that short-term interest rates will necessarily soon be raised. Nevertheless, many investors will still choose to worry about this.

Summarizing these factors, current risks are as follows:

  1. Stronger economic releases become the catalyst for a short-term correction in markets and the commencement of QE tapering a justification for a more protracted consolidation of the gains made in equities over the last few years.
  2. Related to the above is the possibility of further turbulence in emerging markets from rising bond yields.
  3. Profits growth disappointment. Company earnings need to start growing more strongly in order to justify higher valuations and counter the impact of rising bond yields. Stronger economic growth should support this but it does imply that companies will have fewer possible excuses for any disappointments and can therefore expect to be more severely punished in stock market terms.

The more optimistic sentiment that prevails currently among equity investors is, in the short term, a further potential negative factor from a contrarian standpoint. It implies that any specific risks or disappointments might be sufficient to trigger profit taking from here.

For this reason, in the very short term our stance is one of cautious optimism. Over the medium term, our positive stance is undimmed, however, for the simple reason that stronger, non-inflationary growth is the perfect backdrop for equities.

Simon Wood is investment director for multi-manager at SWIP

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