What could trigger a pullback in stocks? Macquarie has a number of concerns
Stocks are soaring before the year’s end but Macquarie has raised concerns of a pullback amid stretched valuations, sliding US economic resilience and a fear of Donald Trump’s policies.
US stocks hit record highs and the Australian market follows; it’s been the same pattern all year despite falling expectations for corporate earnings growth and interest rate cuts.
Australia’s ASX 200 benchmark hit a new high of 8514.4 points on Tuesday before closing up 0.6 per cent at 8495.2 points. It was the third consecutive record high daily close.
Despite potentially negative effects on China and inflation risks from Trump’s tariff plans, the ASX 200 has soared 4.5 per cent since the US election, taking its year-to-date rise to almost 12 per cent.
The ASX 200 total return index is up almost 15 per cent, making it a better-than-average year.
The consensus estimate for aggregate forward earnings per share estimates has risen about 2.4 per cent in the past two months – giving hope that the long-awaited “trough” in earnings growth is in.
There’s also been about 0.5 per cent of PE expansion, even as RBA rate cut expectations have been pushed out to May and some forecasters like HSBC warn that interest rates might not be cut in 2025.
The market is now trading on a 12-month forward PE multiple of about 18.2 times, near its highest levels since early 2021 when interest rates were just a fraction of their current levels.
It’s a bullish time of year for stocks. In the past 30 years, the ASX has risen 1.64 per cent on average this month. Underperforming active funds may be trying to catch up to the market after a better-than-expected year, but this applies more to US funds with a December 31 year end.
Fund managers could also be putting money to work before liquidity dries up at the end of next week.
Falling volatility has helped since the US election. The VIX index of implied volatility in S&P 500 index options has dived to a below-average 13.3 per cent after averaging 19.5 per cent in October.
There’s no obvious catalyst right now; volatility can flare at any time, as it did in December 2018 when the S&P 500 fell as much as 15 per cent, forcing the US Federal Reserve to pivot away from rate rises.
So despite the current bullishness it’s worth considering what could go wrong for stocks.
The elephant in the room is the Federal Reserve Open Market Committee meeting in two weeks.
Money market pricing implies a 75 per cent chance of a 25 basis points rate cut.
If the FOMC decides to further slow the pace of rate cuts by skipping a meeting then it could hit stocks.
US non-farm payrolls data this week and US CPI data next week will feed into the Fed’s decision.
But if the US market sells off because the Fed pauses on the basis of a strong economy, the stock market may quickly recover. As has been the case this year, growth trumps interest rates.
Perhaps an unexpected slowdown in the US economy would be more worrying.
While the S&P 500 hasn’t taken much notice of US bond yields this year, it could track a fall in bond yields for a while if growth jitters emerge. The US 10-year yield looks to have peaked on the chart.
This is basically Macquarie Equities’ argument for a correction in stocks
The investment bank also believes that the sharemarket would start to worry about Donald Trump’s policies.
“The economic surprise cycle looks to have peaked in mid-November, around the time of the recent peak in US bond yields,” Macquarie’s Australian equity strategist Matthew Brooks said.
“With sentiment bullish, a new surprise down cycle, plus uncertainty about what President Trump may do – we suggest reducing risk.”
An upturn in US economic data surprises since early July has coincided with a 10 per cent rise in Australia’s ASX 200 index which accounts for most of its 12 per cent rise this year. But returns in a US economic surprise down-cycle are lower, with annualised returns closer to 2 per cent.
Fear of missing out of the stock rally and the level of exposure of stock exposure on the part of active investors is elevated, and uncertainty over US tariffs and other Trump policies that could potentially impact global growth “could be the catalyst for a correction”, according to Mr Brooks.
“In expectation of a shift to negative surprises and ahead of Trump’s inauguration, we favour some shift to defensives and bond proxies from Financials and other yield beneficiaries,” he said.
It’s a bit early to be sure that US economic surprises have peaked after the US ISM manufacturing index beat expectations on Monday. And while a shift to an economic surprise downcycle should dampen returns, they could still be positive as lower yields support valuations.
“Especially when surprises turn negative – expected in late January – we would expect defensives and sectors that benefit from lower bond yields to outperform,” Mr Brooks said.
Healthcare stocks like CSL and ResMed, gold miners like Newmont and Northern Star, and property trusts including Mirvac and Charter Hall are tipped to outperform. Stocks which could be hit by disappointing US economic data include banks, insurers and Computershare and Challenger.
But US economic-surprise cycles are typically “short and sharp” with a duration (up and down) of about six months, and the market might be on the back foot by the time of Trump’s inauguration.
“Based on a peak in bond yields in mid-November, we could see a trough in negative surprises in the middle of February reporting season,” Mr Brooks said.
“If this scenario plays out as expected, February could be a better time to add cyclical exposure.”
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