US chemical activity spooks; volatility compression; Apple earnings
Head of Equity Strategy
Summary: In today's equity update we highlight that US chemical activity fell in October indicating that US economic activity will continue to slow down in Q2 2020. In addition surveys in the Eurozone suggest no rebound in the industrial sector or among consumers. The FOMC rate decision tonight will deliver a rate cut but any colour on the current money market operations and hints of guidance for rates near-term will be the focus for investors. We also take a look at US volatility indices and our conviction bet in Q4 being long volatility, the ongoing Q3 earnings season, and Facebook and Apple earnings tonight after the US market close.
Yesterday the American Chemistry Council (ACC) published the Chemical Activity Barometer (CAB) Index for October showing a further slowdown hitting the worst y/y decline since July 2012. The ACC chief economist Kevin Swift notes “The CAB signals a pronounced slowdown in U.S. commerce through the second quarter of 2020”. In period 1916-2018 this index has rarely gone into negative growth y/y and rebounded again. When it goes negative it often extends the decline in tandem with general industrial activity and potential recession. This is just another reminder that the macro numbers are signaling a major rebound although equities are discounting such a scenario. More importantly the CAB Index also showed mixed demand profiles in plastic resins which are used in packaging and for consumer and institutional application. This indicates a weakening consumer narrative. This morning the various Eurozone surveys on economic confidence, business climate, industrial confidence, services confidence and consumer confidence in October also show persistent weakness. Adding it all together the next two months are going to be crucial for equities and financial markets in general.
The key event today is the FOMC rate decision and subsequent press conference. The market is pricing in a 95% probability of a rate cut which means that the Fed will deliver this to the market. But two main questions will drive price action tonight. First, many questions will be raised on the current money market operations currently expanding the balance sheet. Initially these activities were communicated as temporary and insignificant but the programme has been extended and increased in size indicating something is not working as expected by the Fed. Second, analysts will be scrutinizing any guidance on the FOMC meeting in December as clues to how the Fed views the situation. The market is currently pricing a 28% probability of another cut in December, so any guidance that indicates a higher probability will most likely lift equities in the short-term.
But cutting rates have a potential interesting dynamic. The initial rate cuts are positive conditioned on the market believing its an adjustment before growth resumes back to trend growth. However, at one point if rates are cut further it signals an economic deterioration that is beyond the scope of the Fed to rectify before it turns into a vicious negative feedback loop. Another rate cut in December go suddenly go from being positive to negative for equity sentiment although most equity decline would have happened leading into a December cut.
As November is around the corner the usual seasonality patterns on equities are brought up by market commentators. The classic being the “end of year rally” and “santa rally”. We looked at S&P 500 returns during the Nov-Dec period in each year during the period 1928-2018 and the result is that the average cumulative return over that entire period is 2%. This explains why investors are even talking about these effects. However, we cannot stress enough to investors that this supposedly positive seasonality effect comes with a highly negative skewness (-0.93) which means that the returns are not symmetric but skewed towards large negative returns. There is no free lunch in financial markets on this time frequency.
One of our conviction trades communicated back in late September are long volatility in Q4 as our thesis is that equities will have to discount a material slowdown in economic activity and subsequent profit growth. This has not happened yet and as of yesterday’s close in the US equity market a long volatility strategy is so far down 16% for the first month of the quarter. However, we are still sticking to our call for now as recent indicators are still making the case for a volatility jump. The VIX Index is currently at 13.22 closing in on the lows for the year. But remember in long volatility trades that you are trading against the contango (positive sloping VIX futures) which means that long positions incur a negative roll yield. A successful long volatility bet requires good timing and an excessive volatility jump.
The Q3 earnings season is little more than half-way done in the S&P 500 with as usual an aggregative positive surprise on both revenue and EPS. While aggregate revenue growth is staying in positive territory at 3.2%, the growth in EPS has turned negative 0.4% with energy, materials and information technology sectors leading the decline.
Tonight, Facebook and Apple will deliver quarterly earnings with analysts expecting Apple to deliver its third straight quarter of negative earnings growth and flat revenue growth. The quarter could be impacted negatively by the iPhone 11 release as buyers have postponed purchasing decisions in previous models. Judging from recent released smartphone numbers in China, the big negative surprise for Apple could be significant decline in revenue in Greater China as Chinese consumers prefer local smartphones over Apple.
Facebook is likely to deliver strong top and bottom-line growth with analysts looking for 26% revenue growth y/y and EPS growth of 29% y/y. The key focus will be on advertising revenue from Instagram Stories and updates on Instagram Checkout which is likely to become the future growth driver for Facebook. But all the good business results may easily be overshadowed by the negative headlines hitting Facebook over how easy it is to place ill-informed political ads on its platforms. The potential negative surprise for Facebook investors could come from higher guidance on operating expenses in 2020 in order to better monitor content placement by advertisers.