Head of Equity Strategy
Friday’s equity rally was a big surprise to us to be honest with the S&P 500 cash index closing only three points from an all-time high based the close prices, with a large part being Amazon pulling itself almost back entirely from the massive opening gap post its Q3 earnings. While the earnings season has been better than expected it has been on a rather cheap backdrop given expectations are implying negative growth and the macro numbers are still negative. Nothing suggests that equities should be close to new highs. But as we wrote in last week’s analysis Are equities right this time? the lower rates globally seem to be driving a substitution effect from bonds into equities, or TINA as it has been formulated “There Is No Alternative”. But is this a healthy backdrop for chasing equities despite falling profit growth? We don’t believe that it is, and our business cycle map is still currently indicating that the prudent position is to be slightly overweight bonds and slightly underweight equities, and within equities focus on quality and minimum volatility equity factors. In other words, being defensive.
Having said that, we have for months been saying on our daily Market Call podcast that we would change our outlook tactically on equities if US equities printed a new high. With the S&P 500 Index only three points away from that event we are close to accept the fact that we have been tactically been wrong.
Another interesting development the last month has been value stocks outperforming growth stocks by the widest margin since the Q4 growth collapse. But for the entire year value stocks have underperformed relative to growth in tandem with collapsing US 10-year yields highlighting the fact that US long yields are key for measuring a change in the growth outlook and hence value stocks. Despite the small tailwind for value stocks the larger picture is intact. Value stocks have been underperforming greatly in the past five years as investors have bid up valuations on growth stocks, but also because the core components in the value segment (banks, mining, industrials and energy) have delivered lower earnings growth.
This week is not only interesting because of very important earnings, but because the FOMC has its rate decision on Wednesday with the market pricing a 91% probability of a rate cut. This is a drastic change from the +80% probability of a rate hike at the October meeting just back in May. The monetary policy narrative has changed much and shows that the Fed is finally acknowledging the downside risks to the economy.
William Dudley the former NY Fed President had a good Bloomberg Opinion piece out today Don’t Let the U.S. Economy Hit Stall Speed arguing strongly in favour of Robert Shiller’s latest book “Narrative Economics” which is an argument for how strong narratives in the economy becomes a feedback loop that is both difficult for the Fed to observe before it’s too late and often binary. The question is where we are on the negative narrative. Our view is that Q4 could become the tipping point if layoffs accelerate due to “kitchen sink” effects from nervous management at large companies not willing any longer to keep excess capacity in anticipation of a rebound in economic growth. But one thing where Dudley comes out naïve is on the US consumer and the low recession risk. The latter has a high 30-50% probability within the next 6-12 months and the US consumer changes also binary with the narrative.
Talking about narratives this week also has a potential US-China press conference on the scopes for a trade deal, so this should be on the radar the entire week. The US-China trade war has been one of the key engines behind the slowing economy and any change in tone could help sentiment.
On the earnings front the biggest events this week are technology earnings from Alphabet (Google’s parent company), Facebook and Apple. These three companies have a combined S&P 500 Index weight of 9% so obviously important for whether the S&P 500 continues higher into unknown territory. Analysts expect another quarter of negative earnings growth for Apple while Alphabet’s earnings growth is expected to have declined to only 5% y/y. Only Facebook has still a very upbeat expectation with EPS growth expected at 28% y/y as the social media giant continues to take market share in online advertising and monetizing its Instagram business. Last Friday we also highlighted the other important earnings to watch this week with major health care stocks taking center stage.
For all the talks about all-time highs in equities and better than expected earnings releases the changes in 12-month EPS expectations for S&P 500, STOXX 600 and MSCI China are still uninspiring for 2019 indicating that the entire rally this year is based mostly on multiple expansion and TINA effects.
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