Stockwatch: Reinforcing the case for equities

So, is this a long-overdue "market break"? On Thursday 17 August, the US market indices fell the most in three months due to "political turmoil in Washington", although ructions from a Trump presidency were inevitable.

This month has seen the biggest two-week decline in US equities since last September, with the Nasdaq down four consecutive weeks - the most since May 2016 - and the small-cap Russell 2000 index has turned negative for 2017.

It's a modest correction, though, and the S&P 500 is still up nearly 9% this year.

As ever, Wall Street is pied piper and global markets follow its tune; it's why shareholders need to remain wise of US events. Mind the noise, though: bearish comment especially gets highlighted for the media to grab attention, and which may include traders short of stocks.

Bosses of asset management firms are quoted for balance with a typically reassuring message: any fall is just a shake-out and the long-term attractions of equities remain intact.

Equally, they have an agenda: to avoid clients panicking for the exit. Where's an objective stance?

Mixed corporate reporting but no firm trend to warnings

Short-term focus it may be, but quarterly revenue/earnings reports are the crux for sentiment towards equities. Selective warnings have gained coverage, for example Cisco, the IT networking major often seen as a bellwether of the business cycle, has seen a 4% like-for-like slip in Q2 revenue.

Shares in farm equipment group Deere & Co fell 7% to a three-month low after missing sales forecasts, and Foot Locker Inc - the US/global equivalent to JD Sports Fashion or Sports Direct - is down 25% after missing profits forecasts.

Besides the misses are beats, however, such as Estee Lauder on both sales and profits, and a consumer sentiment index has jumped from a 93.4 reading in July to 97.6%; also jobless claims are down sharper-than-expected.

Such examples affirm a mature business cycle albeit no serious break-down, and low interest rates may well continue to sustain business/consumer confidence.

Thus, market drops get bought into, though it's essential to keep tabs on this balance of corporate reporting. Q2 2017 has broadly affirmed the case for equities.

Drop in US jobless claims has a twist also

The fall near a six-month low was interpreted negatively because some in the market reckon it hints at higher interest rates. The Federal Reserve is in a quandary to contain the inflationary effects of a tight labour market, albeit with the economic cycle possibly turning down - i.e. classic "stagflation".

Such fears have been fuelled by softer-than-expected manufacturing and industrial production numbers.

Yet higher inflation also helps the Fed to manage interest rates; its current dilemma being that the equilibrium interest rate (where demand for money equals supply) is probably no higher than 3% versus 6.5% and 5.25% in previous tightening cycles, which enabled the Fed to cut from 5.25% during the 2007-09 recession.

This never anyway resulted in a meaningful economic boost, which was why the Fed launched quantitative easing - a further injection of money into the system via asset purchases.

Net reigning in of monetary stimulus

Total assets of major central banks have swelled from about $3.3 trillion (£2.6 trillion) to $14 trillion, providing a major monetary boost and driving equity values since 2009. So, expect bouts of anxiety as to where reining it in could lead.

The Fed began to reduce its programme in 2014 and the European Central Bank (ECB) intends to do so from 2018, as well as phasing out negative interest rates.

Mind that European equities have performed very well on the back of stimulus and tend to remain a preferred play by global asset managers; so might this cool the party if expectations shift towards the ECB tightening?

Yet this dilemma was rehearsed before in 2014, when bears insisted US equities would drop and were proven wrong.

The Bank of England's latest round of quantitative easing since the Brexit vote has completed and, while its monetary policy committee seems overall intent on keeping interest rates where they are, Canadian and Australian central banks have more firmly signalled such intent.

Altogether, it's a subtle shift but does tilt away from the largesse sceptics say has created bubble valuations.

Japan may encourage wider adoption of negative interest rates

Negative interest rates are one possibility being mooted; conservative economists object to because it undermines commercial banks' ability to make profits.

Yet negative rates were adopted in Japan from January 2016, amid criticism the effect would prove deflationary, and its second-quarter 2017 GDP has surprised with a 4% hike and its manufacturing index is up for August.

The dilemma for equity investors is that more widespread adoption could be forced by economic downturn, i.e. a surge in profit warnings. Yet it seems most likely central banks will continue to explore and engineer some form of stimulus in a low-growth environment.

Negative rates would again reinforce the case for equities in a desperate search for yield.

Sideways volatility for September

Sellers are about because the story for equities has got tired. It needs a fresh update by way of economic growth or company results; but the narrative is mixed and US markets in particular have soared on expectations for a Trump administration that looks like it is coming undone, rather than delivering on its manifesto.

So be steeled for more down-days, though it will take until Q3 reporting later in the autumn to provide real evidence whether a sell-off is justified.

I'd expect September to continue this pattern of volatility but, if negative interest rates gain further traction as a potential medium-term policy response, shocks thereafter will also provide reasons to buy.

Central banks will try and backstop economies somehow, thus "buy the dips" is likely to continue to prevail.