Consequently, markets across the world retreated sharply, wiping out year-to-date gains.
As always in times of uncertainty, investors look to the past to help give them direction for the future. Currently, the market seems equally divided between the bulls and the bears. Fears of a profit slowdown are compounded by the high level of corporate margins. Indeed, it was the collapse of margins in 2001 that caught the market out. The slowdown in global economic growth five years ago was not catastrophic, and certainly not of the early-1990s’ proportions but the operational gearing made the profit downturn into something much more serious.
Today, the levels of corporate debt are much lower than back in 2000, making companies less sensitive to higher interest rates and falling margins. Mindful of recent mistakes corporations have been reluctant to spend on capex; indeed management has preferred to invest their strong cash flow on M&A thus avoiding bringing excess capacity to the market at the top of the cycle. This should make profit forecasts more attainable as indicated by the recent report season where the number of firms beating expectations increased.
Whether we are at peak profits or not market valuations do seem to be discounting a fall going forward. A P/E of 12 times is way below the peak profits multiple of 22 times reached back in 2000. Current valuations look much more like the mid-1990s where reasonable valuations allowed the equity markets to make healthy gains despite the profits slowdown.
While equities look attractively valued and positive earnings surprises are outpacing negative surprises by almost three-to-one the increased tensions in the Middle East will keep investor exuberance curtailed in the short term.
The recent turbulence seems more likely to be a mid-cycle correction following several years of strong recovery, and not a market crash. Solid global growth has led to a pick-up in inflation as economies exceed capacity and, by raising interest rates, central banks are attempting to manage the pace of growth and keep inflation in check. If they succeed in slowing growth enough to cool inflationary pressures, but not by so much as to cause a recession, equity markets will move ahead again. However, until US interest rates peak, market volatility is likely to remain.
Diane Jones, senior portfolio manager, European equities, Northern Trust Global Investments.
