Investors are well aware that they need to keep an eye on their investments and monitor if they are still performing the way they are expected to, but there are external factors too that can influence portfolios and, as a consequence, portfolio positioning.
Inflation and central bank decisions are the prime examples of that, dictating what investors do with their money – but it doesn’t just boil down to worrying about the latest consumer prices index reading or yet another rate hike on the day they are announced.
And beyond inflation and monetary policy, what other indicators are useful in today’s market? Trustnet asked four experts to highlight which external forces they focus on the most when making their allocation decisions today.
Inflation
One that we’ve become familiar with is inflation, simply because it dictates what happens to rate-setting policy and the risk-free rate from which everything is priced, said Darius McDermott, managing director of Chelsea Financial Services.
“As we’ve seen, inflation can have a huge impact on financial assets. Bonds had a huge sell off in 2022, as did other long-duration assets. If inflation is lower than expectations next month, we could see bond yields fall and prices rise. If it’s higher, the rout could continue,” he said.
“It’s the indicator you can’t ignore at the moment as it is having such a big impact on portfolio positioning.”
Central bank decisions
Associated with inflation is also the risk of a recession and slowing economic growth, but Jason Hollands, managing director of Bestinvest, said that the relationship between markets and economics is a complex one and there is “virtually no correlation between GDP numbers and equity returns”.
“That’s partly down to the fact that many equity markets – especially the UK – are dominated by large, highly international companies with global earnings and are therefore not a very accurate barometer of the domestic economy of where they are located,” he explained.
For this reason, a more important driver of the direction of financial markets than GDP growth is the provisions of liquidity, or whether central banks are loosening policy expanding or contracting the amount of money in circulation.
“Central bank decisions should therefore be watched like a hawk, not just on the day to see if any decisions are made in line with expectations but for hints on where thinking is heading for the future,” Hollands said.
“Slight changes of tone in press releases from central banks, or speeches by policymakers can set market expectations as to whether rates will rise or fall and that affects exchange rates, bond yields and sentiment more widely across equity markets.”
Earnings estimates
While fund managers are closely watching for possible hints around the timing of interest rate cuts and bearing in mind that share prices ultimately reflect future cash flow streams and their underlying ‘discount rate’ back to today’s prices, Lindsay James, investment strategist at Quilter Investors, suggested that one indicator that is “almost perennially useful” is to look at how earnings estimates are changing for the year ahead.
Currently, analysts forecast on average earnings growth of 11.6% for the US market in 2024, after it is expected to deliver 1% growth in 2023.
“If these expectations for earnings growth rise, this would generally be a positive signal – providing it wasn’t borrowing the growth from adjacent years,” she said.
“These forecasts typically shift most noticeably around the quarterly earnings calendar, reflecting not only an ever-changing economic backdrop but also corporate guidance, which tends to err on the side of caution (even though analysts who publish their estimates may not).
However it is not the level of growth itself that is useful (and currently a signal of potentially high expectations), but rather the change, something known as ‘earnings revisions’.
“Earnings revisions are an early indication that expectations are changing and should then lead share prices in the same direction,” James concluded.
Purchasing Manager Indices (PMIs)
Finally Ben Faulkner, communications director at EQ Investors, highlighted PMIs, survey-based economic indicators designed to provide “a timely insight into sector-specific business conditions”.
Typically, they cover services, manufacturing and construction sectors, with the value of 50 indicating a no-change scenario, above 50 improving and below 50 deteriorating conditions.
“Unlike many other data points out there, PMIs offer a forward-looking view. This contrasts with data points such as GDP and inflation which are reported on a back-ward looking basis. This is important as equity prices generally reflect future prospects,” he said.
“If you’re looking to guide your risk appetite within your portfolio, there is evidence to suggest that PMIs have some predictive power when it comes to assessing forward-looking equity returns. As such, PMIs could be used as an input for how aggressively or defensively positioned your portfolio might be.”