Too early to call it the end of equities

Bull markets don’t die of old age; more often they end with an overheating economy, rising rates and tight financial conditions.

So one of the main risks we're monitoring is the possibility that the robustness of the US economy prompts more rapid Federal Reserve rate hikes.

Concern about this risk is evident in recent market dynamics. Rising bond yields on the back of strong US data helped precipitate the sharp equity sell-off earlier this month. And last week, after the release of September’s FOMC minutes, yields rose and equities fell, as investors focused on some Fed officials favoring pushing rates into restrictive territory.

But, while we are monitoring this risk closely, we think it’s still too early to call time on the bull market:

The Fed is not as hawkish as market reactions suggest.

• While some Fed members favor restrictive policy, the latest minutes also stated that others are opposed to pushing rates to restrictive levels, and reiterated that no longer referring to policy as “accommodative” doesn't signal a change in the policy path. In our view, the post-minutes rise in yields reflected the market catching up with the Fed, rather than a shift in the central bank’s thinking.

We don’t expect 10-year US yields to rise much further.

• We believe the federal funds rate is on course to peak at 3.25–3.5% in late 2020, with a flat or slightly inverted yield curve. Markets have now largely priced in the full Fed rate-hiking cycle.

Overheating is a risk, but not yet a reality.

• Inflation is at the Fed’s target, and unemployment is below the level at which, historically, the Fed would expect inflation to rise. But inflationary pressure has not picked up sharply yet. The quit rate in last week’s August JOLTS data, an important indicator of wage pressure, was unchanged from the previous month

There is little sign that higher rates are weighing on the US economy, outside of the housing sector.

• While housing starts and home prices are showing some signs of strain from higher rates, the Chicago Fed National Financial Conditions Index (currently –0.88) indicates that conditions remain much looser than average.

Earnings growth is offsetting rising yields.

• On the back of strong US earnings growth, the equity risk premium, a measure of equity valuations relative to bond valuations, has actually increased this year and, at 3.8%, it remains above its long-term median of 3.2% (since 1960).

We expect the Fed to keep hiking at a steady pace but see little reason for them to accelerate tightening. We anticipate equities will be able to cope with the Fed’s gradual tightening and think strong corporate earnings (we expect 23–24% earnings growth in 3Q18) will continue to bolster the US market. That said, while our US outlook is positive, recent performance has shown it’s not immune to sell-offs, and we prefer the risk-reward in global equities where we are overweight.

The combination of rising rates and a stronger dollar has created headwinds for emerging markets (EM), and we believe it’s still too early to increase exposure to EM equities or currencies. But we do see value in EM USD sovereign bonds (EMBIGD index), which we overweight, given the 6.5% yield and the well-diversified nature of the index.

We are also overweight 10-year US Treasuries. We think 10-year yields now largely price in the rate hiking cycle, with the position benefiting from positive carry and offering diversification benefits. Treasuries are likely to outperform if risks facing equities, such as a China slowdown or an escalation in the US-Sino trade war, materialize.

Bottom line

Bull markets often end with an overheating economy, rising rates and tight financial conditions. But while rates are rising, the economy isn’t overheating and financial conditions remain loose. We think the Fed is still on a gradual tightening path of and that 10-year yields have largely priced in the full rate cycle. Also earnings growth is helping offset the impact of rising yields on equities. So we think it’s not time to call an end to the bull market.

?Please visit ubs.com/cio-disclaimer #shareUBS