The growing discrepancy between markets and macro
Head of Equity Strategy
Summary: Several well-known macro forecasting models are predicting an increasingly higher risk of US recession in 2019. However, models based on actual market data are forecasting much higher and more immediate threats of an economic backslide. Why the difference? And which one to believe, if either.
This week will prove pivotal for direction in the short term. Tomorrow there might be a vote in the UK parliament over the Brexit deal offered by the EU, but given that surveys indicate that May cannot muster a majority it may be cancelled. Either way the UK situation is dire and adding to the uncertainty, EURGBP 3-month implied volatility has reached levels not seen since the Brexit referendum in 2016 as traders prepare for big swings as the showdown looms.
The conflict between the US and China also seems to be gaining momentum with the detention of Huawei’s CFO, accused by the US government of breaching US sanctions against Iran. This was one of the key drivers behind the weak sentiment in US equities last Friday.
The market and macro discrepancy is growing bigger
The NY Fed has a recession model built on the Treasury spread and this model has seen its 12-month recession probability jump to 15.8%, the highest level since October 2008. However, the big question is how much weight to put on the Treasury spread given that the Fed has been so active in Treasuries for years and is now reducing its balance sheet.
In our world, the Treasury spread is being held up as the ultimate indicator on US recessions but this time it may be reflecting friction stemming from Fed activity, but more importantly, the number of US recessions to test this indicator is so low that no one should put too high a weight on its predictability. Or least, be humble and acknowledge that’s not perfect and should be coupled with other indicators. Bloomberg also publishes a macro-based US recession probability index which in October stood at 2.4%, indicating a very low probability that the US economy is already in a recession. This indicator needs to be above 20% before it gives indication that a recession is pending.
We could have shown many other macro models forecasting recessions and they would on average show around 10% probability for a US recession in 2019. Now, if we look at models only using market input the probability would be closer to 25-30% indicating an interesting discrepancy. Market action is implying greater risks than what current macro data suggest when modelled against previous recessions.
If the market is overshooting against the true probability then there will likely be an interesting rebound opportunity in equities very soon. On the other hand, the macro models may be facing a false negative (i.e. not indicating a recession but it happens in 2019). This is the ugly truth about predicting the future. We can never be too sure about the outcome. For our part the 2,600 level in S&P 500 futures is important and if taken out could drive significant selling pressure short-term. Also worth noting is that liquidity is currently low in the US equity futures so large selling pressure could have some non-linear effects during a single session.
The detention of Huawei’s CFO takes conflict to new level
Ten days ago when Canadian law enforcement agents arrested Huawei’s CFO the US-China conflict was catapulted into a new level. One thing is carrying out policies against specific companies (ZTE) but another thing is to go after individuals. It raises the question whether we could see American technology executives being arrested in China. In her recent NY Times opinion piece, Kara Swisher (one of the best connected journalist in Silicon Valley) explains that this is indeed possible given the conversations she has had with Silicon Valley executives. But more importantly, she suggests that the US and China is battling for 5G network power and so far Huawei has been a winner, seeing its revenue and influence grow around the world while US-based Cisco seems to be forever stuck in the mud.
Adding to the ongoing conflict, the Bureau of Industry and Security in the US will soon release a review of controls for certain emerging technologies and it seems biotechnology partnerships between US and Chinese companies will end, also likely impacting the number of Chinese students who can study in the US.
Outside the Huawei case, a Chinese scientist, Zhang Shoucheng of Stanford University, died on 1 December (same day as the arrest of the Huawei CFO) with no official statement as to the cause. But it worth noting that his $400 million venture capital fund, Danhua Capital, is under investigation by the Office of US Trade Representative (USTR) as the agency is cracking down on what the US government sees as a Chinese infiltration of Silicon Valley.
Between 2015 and 2017 around 13% of venture capital deals had Chinese investors as participants. According to the USTR, China has deployed a new tactic in “technology transfer” since 2014 by subsidising so-called “guidance funds”, or state-backed funds if you will, that are incorporated as venture capital or private equity funds that then invest in many US technology startups. These revelations just add another layer to the complex relationship between the US and China. No matter the outcome on trade the technology battle will go on for decades.
Learn the word leveraged loans now
If you have forgotten the word leveraged loans then please take note. This special segment of the credit market took center stage during the Great Financial Crisis and now it seems that cracks are emerging in both the US and Europe in this market again. As our fixed-income specialist Althea Spinozzi highlighted last week on one of our morning calls, bids in the leveraged loan market in Europe are drying up as credit investors are getting nervous.
Recently, the companies Vue and Hurtigruten had to cancel their loan offerings in the this market due to investors pulling out of the deals. The price index on European leveraged loans (see chart) is still screaming "red alert" but the price action in the market is telling us that the high yield credit market is getting shaky and this market is often a good leading indicators of other financial markets. But the recent nervousness is not only a European phenomenon. In the US signs of weakness are also showing and Moody’s recently said that it sees similarities in the US leveraged loan market with those signs observed before the financial crisis started.
Uber and Lyft confidentially file for IPOs
The initial public offerings of Uber and Lyft are probably the most anticipated in the past couple of years. According to Bloomberg News, the two companies have filed confidentially with the SEC and rumours are indicating a market valuation of around $120 billion for Uber, making it by far the biggest IPO next year and likely in the top five of all time.
The timing is bad with equity market sentiment much weaker going into 2019. In addition, documents show that Uber’s revenue slowed in Q3 to 38% y/y translating into $2.95bn but due to its enormous cost structure driven by customer acquisition activities, the company lost $1.1bn during the quarter. If Uber can pull off a valuation of $120bn when losing $1.1bn in a single quarter, it will be the most frothy IPO ever, even beating the optimism (sometimes naive) often put on Tesla’s shares. As the two companies officially publish their S-1 filing statements we will follow up with actually analyses of the upcoming IPOs.
Saxo’s equity market model and Chinese rebound
Our country model has not changed from last week and is still indicating overweight cyclical markets tied to China. These bets will obviously pay off if China manage to kick start the economy and lift sentiment in financial markets. However, note the split between Hong Kong (overweight) and mainland China (underweight). Investors should get exposure in Hong Kong as the valuations are more attractive and the relative momentum is stronger compared to mainland China where shares are still suffering from extraordinary weak sentiment.
As we pointed out in our equity update on 29 November there is growing evidence that the credit transmission in China is severely impaired and the latest stimulus does not seem to have lifted share prices on Chinese banks which is not a good sign. We are very mixed on China at this point. On the one hand we do see a path to a rebound in Q1 but on the other hand the market is putting strong sentiment on Chinese banks and the market action does not rhyme with optimism. Over the past couple of weeks the probability of a strong Q1 rebound has gone down.
It’s interesting to see the model putting an overweight on UK equities given the perceived weakness and the looming Brexit showdown. This is probably where one should consider overriding the model’s views as the Brexit event is so unpredictable that one should not have too much exposure to UK equities before there is clarity.