Back to reality. After a highly enjoyable five days hurtling down the ski slopes of Crans Montana, accompanied by junior outside of his lessons, a new week has kicked off with Sino-US trade and Brexit still holding sway across markets.
Having suffered from trade headline whiplash late last week, equities in Asia and Europe exuded a degree of optimism on Monday, although Wall Street was an outlier, as the US and China are set to resume their trade discussions in Beijing. A likely scenario is that the talks will continue into next month, requiring a freeze on tariffs that are due to rise at the start of March. Clearly, if higher US tariffs do transpire, equities look vulnerable, but an extension may not help either.
Here’s some food for thought from Bank of America Merrill Lynch:
“An extension with little sign of meaningful progress (no narrow deal on trade) may now be a disappointment. And limited visibility on the timeline for resolution would add to the pressure on global trade.”
As for Brexit developments, the situation remains very fluid and the pound looks fragile (see Quick Hits below). The macro cost is clearly evident with the latest UK data on Monday showing a further softening in the economy.
That’s not just a UK story. In the past week, a number of central banks (European, UK and Australia) have lowered their estimates of growth for this year, affirming why leading global sovereign bond yields — German, US, UK, Japan and China — loiter at levels seen in late-2016 and early 2017. In turn the US dollar is extending its winning streak versus its major rivals, thereby tightening financial conditions and also challenging the bullish mood in emerging markets.
Before my week away, I highlighted the importance of the German 10-year Bund yield staying above its line in the sand at 0.15 per cent. Now, zero bound, last seen in October of 2016, may well ensue. That’s not good news for eurozone banks (see Quick Hits below).
Nearly a decade after the recovery in asset prices began in March 2009, we are staring at an uncomfortable truth: slumbering sovereign bond yields and a lack of inflation has kept central banks stuck at the lower bound, having already spent plenty of ammunition on quantitative easing efforts.
Any desire among central banks to try and return to what is termed a “normal level” of interest rates remains a difficult act to pull off given the sensitivity of asset prices to even a modest bout of tightening. The US Federal Reserve has halted overnight interest rates at an upper band of 2.5 per cent, while other central banks can only dream of getting to such levels.
In the US, one very interesting forecast arrived on Friday via the New York Fed, with researchers citing tighter financial conditions (as measured by the spread between the yields of Baa corporate bonds and Treasuries) for slowing the pace of the economy’s projected growth this year to 1.6 per cent. Last October they forecast growth running at 1.9 per cent in 2019.
That pace leaves the US vulnerable if a macro shock erupts, argues Oxford Economics:
“As growth slows towards 2.0 percent, the US becomes increasingly vulnerable to external shocks, both from abroad and internally. Those shocks loom larger in the face of mounting woes overseas and uncertain trade talks with China.”
The key questions for asset allocation are neatly summed by Longview Economics:
“What’s next? Is this recent global economic weakness a soft patch/mid-cycle slowdown? Or is it something more sinister? Has the bout of volatility in equity markets now passed? And will bond yields fall much further?”
A decline in bond yields from here would be worrying as that would reflect further evidence of weaker growth and rising disinflationary pressure. True, lower bond yields at the moment should help the global economy.
They also bolster the valuation argument in favour of equities and credit.
At present, the spread of US Baa credit versus Treasuries has compressed from 250 basis points to about 230bp, but last October’s level of 180bp looks challenging to say the least. Credit was cheap in December, and as a trade that looks like one to fade from here.
As for Wall Street the valuation assistance from low Treasury yields fades if earnings growth keeps being revised downwards. This brings us to the crux of the matter. Plenty rides on a rebound in earnings growth towards the end of 2019 with the fourth quarter’s year-over-year EPS rise for US companies estimated to reach 9.5 per cent. Wall Street is looking beyond an earnings recession for the first half of 2019. But Q4 is well beyond the horizon at the moment and yet this is the feel-good scenario that risk assets are really hanging their hats on.
Here’s some cold water from Morgan Stanley, which notes that while such a US earnings rebound has occurred in the past two decades:
“These inflections were all related to 1) comping against negative or slower EPS growth or 2) tax cuts mechanically lifting the growth rate. Neither of those forces are at play this year. In fact, it’s the opposite making the achievability of these estimates even more unlikely.”
A sense of caution towards equities is warranted argues Andrew Lapthorne at Société Générale:
“We also know that, except for 2009 (when global equities markets became extremely ‘cheap’, trading on 9.0x forward P/E vs 14.5x today), it paid to be cautious factor-wise during those years when 12m forward EPS growth was negative.”
A dive into the S&P 500’s best performing major sector this year — Industrials, up about 14 per cent — shows how one specific company, Boeing, which is the Industrials index heavyweight, has driven that strong performance. This suggests that slowing global growth and margin pressure, rather than a resolution of the trade war, is the bigger story for investors.
A glance at the S&P 500 sectors since the broad market peaked last September illustrates how those that are economically sensitive remain in or near correction territory, defined as a drop of 10 per cent.
The recovery in many areas of the US and global equity markets remains a work in progress and one that will require a fundamental improvement in economic activity and earnings growth.
Still, it’s hard to ignore the whisper of a late-economic cycle breeze, even for the US and its many multinational companies feeling the global squeeze and the affects of a firmer dollar.
Quick Hits — What’s on the markets radar
Pound options souring — An important barometer for any currency is the activity in options. For sterling, its three-month risk reversal has fallen to a low of -2.5 seen previously in November. A negative reading signifies more hedging against the risk of a sharp drop in the currency.
As Fred Cleary at Pegasus Capital points out:
“With the spot currency moving a bit lower but still 4 points above the lows seen before last month’s meaningful vote it seems clear risk of further downside in spot cable, not least with the reversion in interest rate expectations following the BOE’s QIR.”
The S&P’s ceiling — The broad market has notably failed to rise beyond a key measure of momentum, its 200-day moving average (currently at 2,743) since the market cracked last October. Prior to that break, the 200-day MA was a very strong support level for the market.
Here’s Matt Maley at Miller Tabak + Co on why this matters:
“There is no question in our minds that whether the S&P can break and hold ‘meaningfully’ above that line over the next week or two is going to be very important to how the stock market acts over the rest of the 1st quarter.”
Eurozone banks and bond yields — Lower US and German bond yields from here entail new lows for European banks. That’s the take from Longview Economics, which point out:
“Other than in the first part of 2018, eurozone banks correlate highly with the movement in US bond yields (as well as with Bund yields). Here’s a chart of banks and 10-year Bund yields. At this stage”:
The Stoxx Europe Banks index has trimmed its new year gain to about 3.3 per cent, down from a peak of 9.8 per cent in late January. The value opportunity touted by many is fading.