A Reality Check in Store for Equities?

Texas Instruments (TXN), the 2^nd largest semiconductor company in the US and 1^st to report this earnings cycle, have delivered a much weaker than expected forecast for the 4^th quarter overnight. Taking the mid-point of the company’s projections TXN write down in revenue represents a 14% Y/Y decline in Q4. The company said that most of their end markets deteriorated over the quarter, reflecting the ongoing synchronised global slowdown, tech cycle downturn and the weight of the trade war. Previously TXN have stated cyclical downturns usually persist for 3 to 4 quarters but this is now the 4^th consecutive quarter of declines with management guiding to an ongoing downturn. This is a representation of what we highlighted as the biggest test for equity markets as US companies report Q3 earnings. The moment of truth is coming as companies report a more sombre outlook into 2020 which is not in keeping with the consensus expectation of a recovery in FY2020 EPS growth which is one dynamic underpinning valuations and driving multiple expansion.

Macro data also continues to deteriorate and the 2H recovery touted earlier this year by some is ever elusive, last week’s China trade data was weak, imports and exports both fell by more than expected. Yesterday South Korean exports for the first 20 days of October posted a 20% decline from a year earlier so it looks like exports will contract for the 11^th consecutive month once the month is out. South Korean data is typically a bellwether for global trade, giving a good read on the health of the global economy and global demand given that its industries are heavily integrated within the global supply chain and highly cyclical. It is for this reason that South Korean data is often used in global macro leading indicator models and expectations of future earnings growth and world trade growth, so this latest round of ugly trade data tempers any optimistic notion of a recovery in tech demand and global demand being around the corner. Coupled with TXN’s sobering outlook, the 39% YTD run up in the Philadelphia Stock Exchange Semiconductor Index (SOX) presents a stark divergence with economic realities, as we noted last month.

This is not unlike the present divergence from economic realities presented by the S&P 500 flirting, once again, with all time highs whilst data continue to deteriorate. When we cut through the noise of positive trade headlines to the economic data, the message is clear that the global economy continues to slow and the low point in growth remains ahead, not behind. On a trending basis the leading data is still deteriorating, and the direction of growth is still lower as we await hard data catch up to soft. We may be getting closer to approaching a cyclical turning point, but we do not have enough confidence or data to suggest that an imminent growth recovery is upon us. A growth stabilisation could occur next year, but we believe this is too early to position for, risks remain, and more stimulus will be needed along with confidence in improving fundamentals before positioning in pro-cyclical assets is warranted. Underneath the market surface, internals also remain weak. Whilst the S&P 500 is within 1.0% of another record high more than 47% of all individual stocks are below their respective 200-day averages.

The question then, is whether equities, relying on central banks to backstop markets and fulfil liquidity demands along with false trade optimism, can look through a period of weakness awaiting a cyclical upswing in growth momentum, or whether we have another shake out across equity markets. Lacklustre earnings outlooks and companies not being able to meet even the lowered bar on expectations could well be a catalyst for downside correction. Although this year, unlike last, the supportive policy response is already in play globally, so a corrective move is unlikely to be so severe.

On the positive front we have also seen a scaling back of some of the larger tail risks facing the global economy. A hard Brexit looks more and more likely to be avoided and the US and China are continuing to negotiate their way towards a partial deal. Although we don’t believe this mini deal will alter the relationship meaningfully and will only provide temporary relief from long-term bilateral tensions, the fact the two sides continue to engage is a positive. However, for the global economy, a pause on tariff hikes will not have a meaningful impact on growth and we still have the cycle to contend with. There is nothing on the horizon to suggest that already implemented tariffs will be rolled back anytime soon and tariff escalation is still a risk.

So as growth momentum continues to wane, we see no reason to avert from defensive positioning. Large enough upside catalysts are scarce so the present range bound nature of the S&P 500 is likely to remain status quo. It is difficult to see equities breaking significantly higher over next 3-6 months without a clear bottoming in global growth and the risk of recession taken off the table.