Are equities in a “good place”?
Head of Equity Strategy
Summary: The Fed delivered a hawkish rate cut but equities nevertheless made new highs fueled by better than expected earnings from both Facebook and Apple after the US market close. While Powell seems to believe the US economy is in a "good place" equity valuations in the US are getting stretched and on some metrics resembling what we saw in 2000. Yesterday's ADP employment change figure for October was bad news and the 6-month average is now the weakest since 2010. The next three months are going to be critical for equity investors.
FOMC delivered a hawkish rate cut last night as anything else would be fueling exuberance in equities. The guidance provided in the press release and subsequent press conference changed the market’s pricing of a no change FOMC meeting in December from around 70% to almost 80% suggesting that the Fed is simply aligning itself with the market. The market reaction was equities higher with S&P 500 reaching new all-time highs and the USD headed lower. For more in-depth analysis of the FOMC rate decision we recommend reading our FX Update from this morning. During the press conference Powell said that the US economy was in a “good place” due to Fed policy fitting the narrative of the hawkish cut. But is the economy and equities really in a “good place”?
As we have highlighted repeatedly the past 18 months the global economy is slowing down, the credit transmission in China is broken, equity valuations are clearly driven by substitution effects rather than actual profit growth and the strong USD means that financial conditions are tight in emerging market countries. In our view the Fed is not getting ahead of the curve by aligning itself with the equity market and Fed Funds futures as these two markets are not in line with the current trajectory in the economy. Normally, we show S&P 500 valuation using our standard model of nine different valuation metrics, but today we feel it necessary to show the current ratio of EV/EVITDA in a historical context. As the chart shows, equity valuations are flirting with dot-com bubble levels. Not an ideal starting point for good long-term returns. One must begin questioning whether the Fed’s policy is now starting a bubble in US equities never seen before.
Yesterday’s most interesting data point except from the FOMC rate decision was the ADP employment change figure for October at 125K beating estimates of 110K, but September’s figure was revised down to 93K from 135K. On a net basis the employment situation is worse during the Sep-Oct period than expected. The 6-month average declined to 112K which is now the lowest level since September 2010 and the loss of momentum in the US labour market in 2019 is eclipsing the slowdown in 2011. The US economy is entering a critical phase as the slowdown in the labour market could begin changing the narrative among the consumer. These inflection points where the narrative changes are often sudden and makes it difficult for the central bank to offset.
The last couple of days rumours of a merger between Fiat Chrysler and PSA (parent company of Peugeot) came true this morning with the two carmakers announcing a board agreement to combine the two groups. The combined entity is expected to get €3.7bn in cost synergies and the combined group will complement each other globally in terms of geography and brands. Fiat Chrysler shareholders will receive a special dividend of €5.5bn as part of the deal. The two groups will each own 50% of the new combined entity. As competition is heating up in the global car industry with large new Chinese carmakers and an expensive transition to electric vehicles the merger might turn out to be the right thing.
Adding to the positive sentiment in US equities pushing the key indices into new all-time highs was positive reactions to the Facebook and Apple earnings releases. Facebook delivered strong revenue growth of 29% y/y and EPS growth of 21% y/y both beating expectations. Simultaneously with Facebook reporting earnings Twitter announced that they are banning political ads globally on their platform putting pressure on Facebook to make similar move or at least tighten the control more. The potential canary in the coalmine for investors in Facebook was the EBITDA margin declining to 48.7% the lowest level since Q1 2016.
Apple’s earnings were a story of revenue and EPS beating estimates but also a story of iPhone revenue down 9% y/y and iMac revenue down 5% y/y but importantly offset by Services (app store sales etc.) and Wearables etc. The most positive thing in the earnings release was the flat revenue growth in the Greater China segment which indicates that Chinese consumers are not completely abandoning Apple’s products.