U.S. Equities: Time For A Breather
The equity market has likely entered a correction phase, although improving fundamentals should help limit downside.
The equity market's impressive rally since March may have been a case of too-far-too-fast. Technical conditions are stretched, leaving stock prices vulnerable while investors await evidence that the "second derivative" bounce will turn into a sustainable economic recovery. However, policymakers are acting forcefully to put a floor under growth and it is encouraging that credit market stress continues to subside: corporate and other risky spreads continue to narrow, while Libor rates have fallen well below levels observed just before the Lehman shock last autumn. Even Bank of America has managed to raise fresh equity capital and boldly announced its intention to repay the TARP funds by September. Dilution is obviously negative for bank stocks, but the fact that the capital market has reopened to the banks is a major step in terms of restoring confidence. Admittedly, the threat of a rating downgrade to U.S. Treasurys reinforces market concerns that foreign investors will demand a much higher premium to continue funding the massive U.S. budget deficit. Still, our analysis of sovereign rating risk across the major countries suggests that debt levels should be manageable given the expected rise in domestic savings. Moreover, downgrade risk for the U.S. is less than for many other developed countries. Bottom line: An equity correction may have begun, but cyclical conditions are supportive of further upside.
China: Equity Investment Strategy Update
Our China Investment Strategy service is looking for Chinese equities to enter a period of consolidation in the months ahead. However, the cyclical and structural outlook remains appealing and investors should stay long.
After the sharp rally over the past two months, all four of the major equity indexes of the Greater China region have become technically stretched. The Taiwanese market is the most overbought in the region, while the Chinese A shares the least, according to our composite technical indicators. A technical correction in greater China markets is increasingly likely, and investors should be prepared for a period of heightened volatility. That said, we do not think the cyclical rally in stocks has run its course and investors should remain long, riding out near-term fluctuations. Unlike much of the G7, none of the greater China economies suffer from an overly extended banking system, debt-laden consumers, or massive fiscal deficits. Moreover, authorities are providing aggressive policy support which should allow these equity markets to continue advancing. Bottom line: A technical correction is increasingly likely, but the risk/return profile of holding equities in the Greater China markets remains favorable.
