- As of September 24th, we are now close to all-time highs this month in the US equity markets – this time with the Dow and the S&P trending higher while the NASDAQ slightly down but still close to the peak in August. In addition, the breadth is expanding, banks stocks are doing better, copper is near a six-week high, and tech remains firm. However, as mentioned last month, this continues to be the bull market everybody hates.
- The S&P 500, Dow Jones are positive this month – to the closing of September 24th (+0.6% and +2.3% respectively) and the NASDQ and the Russell 2000 are slightly negative (-1.4% and -2%). All indices are positive ytd (S&P 500 +9.2%, Dow Jones +7.5%, NASDQ +15.8% and Russell 2000 +11%).
- This resilience in the equity market is turning out to be the late cycle extension that many bears did not expect. The facts are that the 10yr is back above 3%, which typically creates investor anxiety. However, historically, bond yields and stocks tend to trade together until the 10-year gets up around 5%. Going back to the early 1960s shows that when the 10-year goes higher, stocks tend to follow along – during 23 periods of rising rates, the S&P gained 19 of those times. This trend is even more pronounced recently – since 1996, stocks gained all 11 times we saw higher rates. So far, you could argue this has been the case in the current period of higher rates which began in September 2017 – as the S&P is up another 11% since then.
- Clearly, we are seeing many rosy indicators in the market, so what could possibly go wrong? Well, it seems that tariffs have come back to dominate the headlines in September with Trump's announcement enacting 10% tariffs on $200bn of goods, effective yesterday, Monday Sept 24th, that will increase to 25% at the end of the year. This is in addition to the 50bn of tariffs that are already in effect at 25%. In addition, China has announced retaliatory tariffs on $60 billion of goods, as well as cancelling additional meetings with trade delegations (probably after the mid-term elections in early November).
- In spite of this announcement, the markets have been buoyant. While many were preparing for a market correction when the tariff announcement hit this month, markets have instead rallied across all regions. Notably, dips are being bought at a historically tough period for the market - recall that three weeks ago, the S&P closed down every day of the week, and the following week closed up every day. As evident last week, the S&P charged to all-time highs and since the trade announcement not much has changed. So what is going on here? It seems most investors seem to be exhausted of tweets and trade tariff threats. Unless there is something particularly severe or imminent in any announcements or tweets, it is possible that the market may try to see through headlines this time around particularly given the earnings backdrop.
- Thus the bull vs bear debate on where we are in the cycle given how the markets shrugged off the tariff news this week, can be highlighted as: 1) the base case on the trade conflict will remain in an escalatory cycle as the US and China are at a fundamental impasse, 2) This base case for trade will continue to include any announced measures from here until a circuit breaker emerges; the most likely source is solid proof of economic weakness caused by the trade tariffs, 3) The bulls say that no matter how bad the tariff news flow or tweets get in the near-term, global economic fundamentals are still broadly stable and strong. This is coupled with Q3 earnings expectations in high teens after seeing two sequential quarters of ~20% y/y earnings growth. Those bullish believe that the market has already priced in any impact from tariffs, given multiple contractions we have seen for equity markets globally. This, perhaps, is the reason for why there has not been any recent market corrections on the tariff announcements.
- What do the bears say? Many believe that margins are peaking, earnings are slowing down, and that indicators show the start of a rolling bear market – and therefore that the market has misjudged the risk and potential fallout of these deteriorating macro conditions. However, many bears have been perhaps been too skeptical by overestimating the impact of tariffs on the market. Bears will argue that investors remain too complacent and are missing the underlying risks. They believe tariff escalation could possibly lead corporate managements to hesitate to be proactive in capex spending, M&A and other investments. To further substantiate the bearish view, going into Q3 earnings, companies may be challenged to sustain spending and investing when costs are already going up and comps will be tough.
- Thus, it seems trade worries have been pushed to the beginning of 2019 and the focus has shifted back to economic growth, corporate earnings, and a 17x multiple for the S&P.
- Speaking of more bull vs bear debates, the credit market in the US offers an interesting discussion. Some argue that corporate credit fundamentals have deteriorated across the credit spectrum – IG, HY, and Leveraged Loans, as companies have engaged in a debt binge over the course of this cycle. This has been ongoing for some time and a reason to be concerned, but ultimately not an area where there is a clear catalyst just yet. Tax reform is giving companies more money to meet debt related obligations. The bull case for the IG market is that M&A supply has been digested well and the market is tighter. With the rate move, the all-in yield of the market has attracted a lot of buying across the globe. Post September, issuance for October is expected to be light at 80-100bb (compares to 120bb from last year). In contrast, the bear case is that the market is flooded with too many BBB-rated bonds and given the recent run, the market is susceptible to a quick correction if treasury yields or stocks stop moving gradually higher.
- From an equity perspective, M&A announced deals are reflecting high deal certainty, implying that credit (and the potential bear case) is not pressuring these deals. Debt capacity exists for strategic and private equity deals and committed financings are getting done, which is also a positive for deal certainty in existing deals. Thus, one could remain optimistic about future mergers and LBO financings. The current leverage finance backlog stands at $79B ($15B in high yield and $64B in leveraged loans), which is not even close to the $350B/$400B at the peak during 2008 financial crisis – so there is still plenty of capacity remaining for new committed event transactions on underwriter balance sheets. M&A activity will remain strong as many of the ingredients necessary are still evident. There are still strong company fundamentals, board confidence is high, we are still in a “low growth” environment (which is positive for deal-activity), uncertainty around tax reform has passed (had been an overhang for the last year), private equity has a lot of capital, and activism seems mature and seems here to stay ie - high profile activist events like Whitbread (WTB LN), United Technologies (UTX) and Nestle (NESN SW). In regards to potential threats to M&A activity, it will likely be a tougher regulatory environment, valuations being too expensive to pay control premiums and still make the accretion math work, and China trade/tariff pressure.
Europe, Japan and Emerging Markets
- European markets have stabilized in the latter part of September, with the MSCI Europe +0.7% mtd and -1.75% ytd, and the Eurostoxx +0.6% mtd and -2.6% ytd. However, Europe continues to capture attention with new geopolitical headlines, with the UK and Italy stealing the show. Arguably, the Italian Budget and Brexit are the two biggest macro hurdles for investors to get over before we can start to see flows back into European equities. On the risk front, Italy looks to be walking back from the dangerous 3% budget deficit cliff. On Sept 27th, the Italian government will release its fiscal plans. While the goal is to use the budget to boost growth, policy-makers are not keen on breaching the 3% budget deficit rule set by the EU. If the final budget deficit is under 3%, this could alleviate market concerns around risks of a larger budget deterioration and bring up sentiment. A surprising lower deficit goal closer to 2%, could be very bullish for European equities. The domestic segment of the equity market is pricing too much of a negative outcome for the Eurozone. Resilient Eurozone consumer sentiment and improving labor markets should help domestic focused equities.
- The inflation outlook in the Eurozone may be starting to change, as inflation expectations are rising. Wage pressures measured by hourly wages and salaries, are now +2.2% in the 2Q of 2018. In addition, lending growth is accelerating, capacity utilization is becoming tight, and thus one can expect the output gap to continue to close this year. These circumstances led Mario Draghi last week to continue to stress the ECB’s plans to ease the monetary stimulus.
- In the UK, PM Theresa May has had a turbulent last week with talks in Salzburg gaining little ground with EU leaders on process towards a compromise Brexit deal. Going forward, it is possible that there will not be a deal in October, and instead, the ultimate trade relationship decision between the EU and UK is resolved in March 2019, after agreeing on a transition period, which provides more flexibility for negotiations. However, it is highly likely that uncertainty remains high until March 2019.
- The Japanese market has been the strong performer in September 2018, with the Topix +5% and the Nikkei +4.7% mtd. The weakness of the Yen and the belief that the Bank of Japan might be beginning to reverse monetary stimulus, as the economy recovers, is improving the sentiment of this market.
- Collapsing EM markets had been the main story in August and early September. However, more recently they have stabilized. The MSCI Emerging Markets index is still -10% ytd, as well as the MSCI Latam index, also -10.6% ytd. Specifically in China (Shenzen and Shanghai) and Hong Kong, those equity markets remain -24% and -8% ytd. In particular, the collapsing Turkish Lira (-38% ytd) and Argentine Peso (-50% ytd) have been the focus of a lot of the press coverage, even though there are somewhat isolated examples of economies with major imbalances.
- Nevertheless, sentiment toward EM assets remain deeply negative while fundamentals appear much more stronger than in previous periods of stress, particularly when comparing the current episode with that of the taper tantrum in 2013. Most EM economies are less in need of external financing now than back then and their current accounts are much more balanced. While investors have singled out Argentina and Turkey for their imbalances, concern about ensuing contagion seem overdone as EM fundamentals overall do not warrant such a negative approach.
- As trade and political/regulatory concerns dominate China and emerging markets, there could be upside for un-favored developed markets like Europe and Japan.
In the US, the bull market remains intact, even with trade tariff actions being put in place between the US and China. As mentioned before, the bulls are winning and it seems “trade tariff exhaustion” has started to materialize leading to higher equity prices. Our view is to remain invested.
As mentioned earlier, global economic fundamentals are still broadly stable and strong. 3Q earnings expectations are in the high teens after seeing 2 sequential quarters of earnings growth exceeding +20%. Bullish US economic data has continued in September: with strong US Housing Starts and US Manufacturing survey. Jobs growth and wage data, Conference Board’s sentiment indices indicating consumer and corporate executive confidence at its highest point since 2000, all point to an economy that continues to grow.
In addition with share buybacks continuing, capex spending strong and a US economy expected to grow close to +3% in 2018 (after +2.2% in 2017), it is clearly expected for the Fed to increase rates this week (September 26th).
With 10 year rates now at 3.10% and 2 year rates at 2.82% (and 5 years at 2.97%), the US 2 year versus 10 year curve has widened to 26 bps, from 18bps last month.
The “bull vs bear” discussion remains the mid vs late cycle debate, and for the time being the bulls winning over the bears. Corporate earnings remain robust and 3Q expectations remain bullish.
The view for 2019 is that strong growth will be led by the US, inflation will remain moderate with the risk of increasing, continuation of monetary policy accommodation (led by the US and followed by the Eurozone) and developed markets rates going higher. In addition, issuance of Treasuries will increase, and the move from quantitative easing to quantitative tightening will mean higher yields.
Ironically, non-U.S. stocks have been hurt much more by trade worries over the past few months than have U.S. equities. Much of this dispersion has resulted from the corresponding climb in the U.S. dollar, which has made U.S. stocks a relatively safer haven. The fall in global stock prices has probably been excessive, and seems to reflect worse economic and fundamental conditions than actually exist.
Our belief is that Eurozone growth remains intact, with domestic consumption still robust, unemployment continuing to fall and credit growth increasing. If political risks fade, we could experience and important rally in Eurozone assets (particularly equities) that have lagged the US this year. Our view is to remain overweight European equities.
At this point, we think that if trade conditions ease (or if we see more clarity about the direction of trade policy), it would boost global equity markets. Additionally, if global bond yields avoid sharp increases and experience an orderly rise, which would likely remove some risk from the equation.
Overall, we continue to have a pro-growth stance toward global financial markets. For now, we think relative economic conditions, monetary and fiscal policy trends and the political backdrop support U.S. stocks. However, these trends may reverse, or at least become less strong, over the next 6 to 12 months, which could benefit non-U.S. markets.
Our view on emerging market equities is to remain invested but cautious.