Head of Equity Strategy, Saxo Bank Group
Summary: That markets can be wildly unpredictable things was brought into sharp focus by the December washout. Looking ahead to the new year, the outlook remains murky, but China, for all its woes, could provide the seeds of redemption.
Over the weekend, investors got another dose of positive news as Trump and Xi agreed to a “ceasefire” in the ongoing trade war. I had only put a 25% probability on this event in my recent presentation and judging from the market reaction overnight, the market in general had not priced it in. Based on recent events, we expect global equities to rise by 5-7%, so with today’s 2.5% move in global equities almost a third has already been achieved. (Equity Monthly: Were the Fed and the G20 enough?, 4 December 2018)
Literally the days after our forecast things went into a whirl. Equities were brutally slaughtered as global investors fled into secure assets such as government bonds. Growth forecasts for 2019 were coming down and the Federal Open Market Committee's decision to make a relatively hawkish rate hike was too much for the markets. The sell-off intensified.
While being wrong on our short-term call, we did stick to our overall view held throughout all of 2018. That we are late stage in the cycle and that the risk-reward ratio in global equities is getting worse and worse. US investors can lock in almost 2-3% return over the next year with almost zero price risk compared to betting on equities which may return 5-7% but with 30% variance.
The broader question is whether recent events set equity markets up for a rosy 2019. We remain sceptical of this projection despite our current short-term positive outlook. The global economy is late stage and financial conditions have tightened above the historical average. Equity valuations are not outrageous, but they are not cheap either. Our biggest worry is still credit markets that look very vulnerable due to the significant increase in corporate bonds. (Equity Monthly: Were the Fed and the G20 enough?, 4 December 2018)
Markets do not deliver an event like December for nothing. Things are changing and every investor should be worried about 2019. Our tactical asset allocation model Stronghold, which we offer to our most valued clients, has mostly cut risk in 2018 and in December the USD portfolio reduced equity exposure to zero only leaving high yield bonds as its meaningful risky asset.
In our 21 December 2018 equity update we showed simulations of US equities whenever the VIX is in its 9th decile [24.1 – 28.6]. The message was clear. The near-term future will be extremely volatile. Our simulations show that there is likely a 10% probability for US equities being down 16% or more, or up 21% or more within the next three months. At the time of our analysis this translates into the S&P 500 at index level 2,992 or 2,074 by late March. The question is whether investors are prepared. Those with significant equity exposure are running portfolios with very high risk at this point. Our recommendation remains to be overall defensive in terms of asset allocation and stay defensive within the equity exposure component (so minimum volatility stocks).
This morning we ran our global equity market valuation model to see where things landed after December. The z-score measured on an equal-weighted index of nine valuation metrics show that global equities are now at minus 0.36 which is the lowest level since February 2016. Is this a buying opportunity? Valuation models have never been good timing tools so investors should be careful making buying arguments off valuation cheapness.
When fear and reduced growth expectations kick into gear the valuations always go down sharply. If 2019 turns out to be the transition year into a recession (the probability that the US economy is in a recession is somewhere around 10% according to the recession models we track) then the valuation multiple will continue to be under pressure.
The new year has started off with more negative sentiment. Most notably in Asia with Hang Seng Index futures down 3.4% as the Caixin China PMI Manufacturing index slipped below 50 (49.7 vs est. 50.2) indicating negative momentum remains in the Chinese private sector. I admit that I have been part of the positive China rebound story for Q1 but with incoming information I’m revising down my optimism. It looks increasingly as if the China’s government has underestimated the impact from the trade war with the US.
While China has more fire power on the fiscal side our biggest worry is that the credit transmission is broken (as it is in both Japan and Europe) due to excessive debt levels reducing the transmission effect. The chart below shows the four largest banks in China on market cap to total assets. If the credit transmission was intact then this ratio would normally increase in a positive business cycle. The reason is that in a positive business cycle banks extend loans as good margin and credit risk are decreasing, which increases the market value of both existing and new assets on banks’ balance sheets. However, in China we observe investors not buying into banks proportional to their asset expansion. This is not a positive sign in our opinion.