Head of Equity Strategy
Summary: Equity markets are now at an important inflection point and the direction here will be determined by who wins the battle between a global recession and policy makers. Increasing evidence suggest that the slowdown is slowing increasing the likelihood of a macro turning point within the next couple of months. If the global economy avoids a recession once again it could send equities higher. But if policy makers are fighting the inevitable and the downside forces are too strong then equities will face a turbulent 3-6 months.
It’s clear from yesterday’s price action during the initial ECB press release and subsequent press conference that the market had difficulties interpreting the projected outcome across all asset classes. Trading ranges across European equities, and especially banks, and bonds. Rates were higher in both Europe and the US, and equities across the board were slightly higher carrying into Asia session overnight. But markets in general are at an important inflection point with big forces at play. It’s essentially a battle between economic forces pulling towards a recession against policy makers unleashing yet again monetary stimulus to avoid another recession.
Recession risk vs policy action
OECD’s leading indicators in July showed another month of decline highlighting the urging need for policy makers to arrest the slowdown. First line of defense has once again been central banks, but we are getting to the end station here on central bank effectiveness on the economy as ECB President Mario Draghi also highlighted on yesterday’s press conference. Next phase must include fiscal stimulus. The US is already engaging in massive fiscal stimulus while Europe is lagging. China is also on the bandwagon on both fiscal and monetary stimulus. One thing to note in the OECD leading indicators is that the slowdown is slowing, so to speak, which means that a turning point is probably near. Avoiding a global recession is still possible but it will be a close call. The US economy has 25-35% recession probability within the next 6-12 months.
The Citi Economic Surprise G10 Index rose into positive territory for the first time this year and the highest level since September 2018. With expectations now below current incoming macro data risk-on sentiment could be further supported. If macro data are stabilizing and policy action globally is strong enough, China’s credit impulse has improved dramatically since November 2018, the global economy might once again avoid a recession. It would be remarkable turn of events and opens a path for a significant upside scenario in equities.
Adding to the unusual times US core CPI figures (Aug) yesterday rose to highest level since September 2008 creating a difficult environment for the Fed. However, keep in mind that the Fed’s preferred CPI measure remains still well below 2%. But if inflation is showing its face while the USD is historically strong then the Fed will have to make difficult choice. Should hold rates due to domestic economic situation and risking a strong USD killing global growth? Or does it cut rates to ease financial conditions and help the global economy, but risking accelerating inflation with all its consequences? This conundrum is also highlighted in today’s FX Update.
Did Draghi deliver enough for banks?
Setting intraday volatility yesterday aside price action this morning suggests investors are happy with the two-tier system to alleviate the pain for banks due to negative rates. As we highlighted in yesterday’s equity update the lesson from Japan is that the rally continue as investors are slow at repricing the effects of the tiering system. But the lesson learned is also that the tiering system does not change structural issues that European banks face with too high operating costs, poor technology infrastructure, low loan demand, excess customer deposits and negative rates on government bonds. Structurally we remain negative on European banks despite our short-term optimism driven by the ECB decision and the steepening of the euro swap curve.
Overweight Japanese equities
Rising rates, improving macro conditions and weaker JPY are all driving Japanese equities higher and reiterate our overweight stance. Valuation on Japanese equities is not stretched either compared to say US equities. But make no mistake Japanese equities are a volatile beast so any trader must be alerted to changes in JPY flow and rates. With all the stimulus being thrown at the global economy Japanese equities as a high beta play are still attractive.