Summer rally: will it last?

Financial markets have staged a notable recovery since mid-June. At the time of writing, global equity markets have risen close to 16% from the June lows, whilst the S&P500 index is up over 20% in sterling terms. Fixed income markets have also fared better, despite continued rises in interest rates, with UK gilts and UK corporate bonds both up over 3%. After a tumultuous first half of the year, these recent moves have come as a welcome respite for investors.

The question now is whether the recovery will continue, or will prove to be a false dawn.

What caused the rally?

A significant contributor to market volatility in the first half of the year was concern about rising interest rates as central banks looked to tackle high levels of inflation. Towards the end of June, investor attention began to shift towards the impact of inflationary forces on economic growth and the increased likelihood of a global recession. This in turn increased speculation of a potential “pivot” of central bank policy – ordinarily we might expect central banks to cut interest rates to mitigate the impact of weaker economic growth.

As a result, bad news on economic growth translated into good news for asset prices. Expectations of weaker growth, of more supportive monetary policy and lower interest rates resulted in government bond yields falling, and falling bond yields, in their own right, are supportive for equity valuations. This is particularly the case for more rate sensitive “growth” sectors such as technology, with the tech-heavy Nasdaq 100 index rising by close to 26% since the June low.

At the same time, sentiment has been buoyed by the fact that the second quarter corporate earnings season was not as bad as it was feared. At a headline level, year-on-year earnings growth came in at 9% in the US and 16% in Europe – ahead of consensus expectations. It is worth highlighting that most of the strength was driven by energy stocks. Excluding energy, year-on-year earnings growth was -3% in the US and 6% in Europe. Even so, given investors’ more gloomy expectations, this was still seen as relatively robust.

In the near term, improving sentiment has driven the recovery and momentum is carrying it for now. Markets have become optimistic about the outlook for central bank policy and less concerned about weaker corporate earnings. The question however remains whether the recent period of stronger performance marks the start of a market recovery, or if there is further volatility to come.

What next?

Recent investor bullishness should be met with some caution. Economic activity indicators continue to fall globally.

While corporate earnings have held up better than expected in the near term, earnings momentum continues to slow, downgrades have only just begun and there is the potential for weakness into the end of the year.

Furthermore, while the latest headline US inflation fell, many components of the inflation basket continue to be sticky, suggesting the Federal Reserve (the “Fed”) will remain resolute in its aim of bringing inflation under control. Lessons from the 1970s, when Arthur Burns reduced rates too quickly prompting another inflationary spike, continue to preoccupy Fed governors.

The market may have been too quick to price in a policy pivot in the US. With further economic data releases, the Jackson Hole conference at the end of August, followed by the next Federal Open Market Committee (FOMC) rate decision in September, there is plenty of opportunity for recent optimism to be tested.

History lessons: short-term rallies within longer market downturns

It is worth noting that periods of stronger performance during a more prolonged equity market downturn (a bear market rally) are not uncommon. Since 1885, whenever markets have fallen by more than 25%, there have on average been three rallies of at least 10% which proved to be false dawns. During the Great Depression, there were eight in total, five of which exceeded 20%. The largest came between November 1929 and April 1930, when the US equity market rallied by 48% before falling 30% over the following two months and 80% in the next two years. Failing to recognise a bear market rally has historically proved to be a good way to lose more money over the medium term.

Despite this, and more positively, history also shows that if a rally can result in equity markets retracing 50% of the falls experienced during the bear market, then they have tended not to endure a subsequent sell-off that has exceeded the previous low. The S&P500 has just moved through this level suggesting that we may have already seen the market low point in June.

On balance, it seems premature to assume that equity markets are out of the woods. There is a good chance that recent market performance could turn out to be more of a relief rally than a true recovery. While marginally softer inflation data is positive, the Fed (along with other central banks) remain focused on tackling inflation, not supporting growth. Furthermore, the fundamental backdrop remains challenging with the potential for weaker corporate earnings over the remainder of the year.

In this environment, we are happy to remain underweight equity, with a clear preference for higher-quality companies with the ability to navigate what could remain a challenging market environment.

¹ Source: Samuel H. Williamson, ‘Daily Closing Value of the Dow Jones Average, 1885 to Present’, MeasuringWorth 2020, Schroders.