This week in the markets - shares pause for breath after six-month rally

After a near 30% rally since last October’s low, it is unsurprising that investors are looking nervously at the Middle East and a higher-for-longer interest rate story.

Common or garden correction

Although the S&P 500 is 6% off its end-March peak, with a 10% correction looking increasingly plausible, investors are still holding their nerve. And rightly so. This kind of drawdown is not unusual. Since 1900, in fact, shares have spent half their time at least 10% below their most recent peak level and nearly two-thirds of their time at least 5% down.

That’s because, while shares rise over time, they don’t do so in a straight line. The zigs and zags of the market are part and parcel of being an investor.

The latest pull back is being driven by two drivers - geo-political risk and worries about interest rates. Nothing new there. This has been the story at least since the invasion of Ukraine more than two years ago.

The good news in the Middle East is that it is clear that neither Israel nor Iran want things to escalate further. And President Joe Biden, with an eye on energy prices ahead of November’s election, has made it clear that he won’t let that happen either.

As for interest rates, that looks like a bigger concern for investors. Indeed, every spike in volatility in the past couple of years has coincided with a rise in anxiety about the future path of rates. In the US, a strong economy, robust jobs market and persistent inflation above the 2% target makes the higher for longer narrative look ever more plausible.

That makes it hard to justify a historically high valuation multiple for shares, so the recent decline from 21 times earnings to 19 or so looks fair and unavoidable.

Earnings season underway

All eyes will now be on corporate earnings to see if profits growth can offset a likely further retrenchment in earnings multiple. This is how markets work. Investors anticipate an uplift in profits and then earnings have to pick up the baton to keep markets steady as expectations moderate.

This week sees a big acceleration in the pace of first quarter earnings announcements on both sides of the Atlantic. In particular focus will be the Magnificent Seven stocks which have done so much of the heavy lifting during the market rally of the past 18 months. Both Facebook-owner Meta and Tesla are reporting this week.

The tech stock earnings figures come at a delicate time for these big market leaders because they are no longer behaving as one homogenous whole. While Nvidia, the AI-focused chip maker, has risen 70% so far this year, it is 12% off its March peak. Tesla shares have tumbled 40% and Apple is off 13%. It’s hard any more to see these shares in the same light as Amazon, up 18%, Alphabet 12% higher and Meta up a hefty 42%.

Return of the mighty dollar

One aspect of the apparent economic and corporate divergence between the US and the rest of the world is a growing shift in interest rate expectations on either side of the Atlantic. While both the Bank of England and European Central Bank appear to be heading towards a summer pivot on rates, the US seems more reluctant. That’s not surprising given its history of easing too soon and allowing inflation to rear its head again.

The net result of these diverging rate expectations is most obvious in the currency markets, where the dollar is riding high against all its major counterparts. The pound is back under $1.25 having been above $1.30 recently. In Japan, meanwhile, the yen is now trading safely below 150 yen to the dollar. That’s actually good news for the Japanese stock market, given the boost it provides to Japan’s exporters and overseas earners.

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