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Overview
A sense of foreboding is spreading through emerging markets on concern that China’s slowing recovery and the fast-spreading Delta virus could crimp global growth. Yet the hardest blow could come from a renewed selloff in U.S. government bonds. This upward pressure on US 2-year bond yields is being driven by the market pricing in higher official interest rates from the US Federal Reserve within the next 2 years.
The yield on the 2-year US government bond tends to put upward pressure on the US dollar.
With so much dollar-denominated debt, a stronger US currency tends to weigh on emerging market equities.
Chart 7: Emerging market equities feel the weight of a stronger US dollar
Source: Bloomberg
U.S. stock investors are likely to tilt more defensive as COVID cases rise and economic data weaken.
So far in August, utilities, health care and consumer staples are three of the four best S&P 500 performers, with financials at number one.
There are some sector-specific reasons for the August gains. Utilities have gotten upside from summer power demand and some declines in bond yields over the past few weeks. Health care vaccine stocks have risen on the prospect of a U.S. booster plan. But an underlying thread is rising fears of the delta variant, inflation and peak growth.
Chart 8: S&P Cyclicals / S&P Defensives
Source: Bloomberg
Peak earnings growth doesn’t mean profits can’t drive stocks higher. A key determinant will be if profit margins hold up, and so far, there are encouraging trends on that front.
Some companies are using price increases and productivity gains to offset rising material costs.
In Europe, the Stoxx 600 operating margin on a quarterly basis has rebounded from pandemic lows to over 11%, the highest since 2011. In the US, margins are at 14.2%, the highest on record.
Plenty of unknowns from COVID and inflation remain, but profit fundamentals remain supportive.
Chart 9: US and European equities operating margins
Source: Bloomberg
