Earnings vs. Interest Rates: who wins?

19 October, 2018

Global equity markets failed to resume any kind of strong rebound following Tuesday’s surge.  Asian equity indices are deep in the red today with Chinese stocks leading the decline. The Shanghai Composite dropped by 2% while the CSI 300 fell 1.5%. The selloff in Asia comes after a turbulent session on Wall Street where the Dow Jones Industrial Average, S&P 500, and the Nasdaq all fell heavily at the beginning of Wednesday’s trading session but all managed to close well above their lows.

If earnings were the key factor driving investor decisions, stocks should be rallying by now. Fifty-five companies out of 504 S&P 500 companies have announced their Q3 results with 80% managing to surpass on EPS. If this trend continues, earnings growth will easily beat the projected 20%. However, this is still not helping, suggesting that investors are becoming ever more convinced that we have reached the peak of the current economic cycle.

Minutes from the FOMC’s September meeting reaffirmed the Fed’s hawkishness. The minutes were even more hawkish than what market participants were expecting with some suggesting pushing interest rates into restrictive territory: in other words, beyond their neutral rate.  This suggests monetary policymakers are becoming increasingly worried about inflation rising above its target, given the strength of economic expansion and the low unemployment rate. 

U.S. Treasury Bond yields pushed higher after the FOMC news with 10-year yields back above 3.2% early today. If interest rates continue to move higher from their current levels, investors will become even more reluctant to buy the dips in stocks.

Economic data also didn’t help yesterday with housing starts falling 5.3% in September. Weekly mortgage applications also fell 7.1%: the steepest drop since July 2017. With interest rates seemingly to continue to be on the rise, housing activity in the U.S. should be expected to fall further.

The greenback was the primary beneficiary of the spike in interest rates. The dollar index rallied above 95.7 early today in another attempt to retest October’s high. A break above 96.15 may lead to retest the 97 critical level.

The Yuan fell to a 21-month low after the U.S. Treasury refrained from labeling China a ‘currency manipulator’. With the dollar continuing to march higher, it’s becoming a question of when and not if the Yuan will break 7 per dollar. The Chinese economy requires a weaker currency to offset the current weakness in growth. However, officials will also be considering the impact on outflows if the currency continues to depreciate further. Finding this balance is tricky, but I don’t think the Chinese will aggressively defend a break above 7.  

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