Head of Equity Strategy
Summary: Momentum in equities has faded in most markets except for South Korea and Japan. Earnings growth is slowing rapidly going into the Q3 earnings season in three weeks time. The repo market stress will come back and haunt markets as major US banks are incentivised to shrink their balance sheets before year-end. Overall, too many factors are going the wrong way for implied volatility to remain low. Our new conviction view in Q4 is long equity volatility. In today's equity update we also discuss Apple tax ruling and Netflix shares in bear market.
Momentum across most equity markets has faded substantially over the past week. But we are observing strong momentum in KOSPI 200 and Nikkei despite recent bad export numbers from South Korea. Investors are discounting measures announced a couple of weeks ago that South Korea will increase government spending by 9% next year. Overnight flash PMI figures in Japan were down m/m but less than feared given the ugly German flash PMI figure yesterday. There also seem to be bets on a more positive trade negotiations on the back of the CCP’s 70th anniversary on October 1 given the latest waivers from both China and the US. But overall, we maintain a short-term negative bias on US equities unless they can break into new all-high territory as the market is lagging a catalyst.
The Q3 earnings season is around the corner and expectations are clearly too high with sell-side analysts expecting 9.5% growth in EBITDA over the next 12 months. We fail to see how the current environment with few catalysts can deliver this growth rate when the MSCI World All-Country Index is seeing almost zero earnings growth compared to 18% two years ago. We expect Q3 earnings to disappoint and as we alluded to in yesterday’s equity update, we expect this Q4 to be a kitchen sink for executives as the year’s numbers will not be good anyway. In order to prepare for lower growth companies will likely cut costs and this could start in Q4.
NY Fed President John Williams said yesterday that the worst is over in the repo market despite the Fed clearly was surprised about the recent moves in the US repo market. There has been a narrative inside the Fed that the current $1.39trn in excess reserves were enough to make markets smooth, but the past week has shown why this is not the case. Most of these excess reserves cannot easily be deployed by major banks as their balance sheets are already tight. The largest US banks have all moved one notch higher in the regulatory surcharge brackets since Q4 2018 which means that unless they shrink their balance sheets toward year-end then they will see a 50 basis points surcharge increase. Our view is that USD liquidity will continue to be an issue and tighten further until the Fed is forced to grow its balance sheet again.
The combination of US banks that have to shrink balance sheets, the strong USD, Germany’s economic activity plunging, earnings disappointments and the never-ending US-China trade war is an interesting setup for long volatility in Q4. This is our conviction view for the coming quarter. Either as a hedge for a balanced portfolio and outright directional play. The VIX is currently priced at 14.72.
Today the EU General Court will rule on Apple’s tax order worth €13bn related to its tax agreement with Ireland in years 2003-2014 which the EU says was illegal. The court ruling is important as later this week smaller tax rulings will be made on the tax cases against Starbucks and Fiat Chrysler. The EU is generally looking into US companies’ tax avoidance behaviour and today’s ruling on Apple will likely set a precedent and could have an impact on earnings per share as the effective tax rate will be lifted if the court rules against Apple.
Technology stocks have been strong again this year but one technology company, it’s more a media and entertainment company, has not done well and that’s Netflix. The stock is down 31% from the highs in July as the company reported Q2 subscriber numbers, especially the drop in US customers, that negatively surprised the market. Sell-side analysts are still in the denial phase that growth could be slowing maintaining a consensus price target at $379 around 43% above yesterday’s close price.
The fundamental problem with Netflix’s business model is it seems it takes more and more content acquisition to maintain the same growth rate. In terms of cash flow dynamics Netflix pays out cash flow upfront and collect it over time leading to deteriorating cash flow from operations as the business grows. On top of that Netflix’s is not able to sustain global growth rates of 27% y/y with internal generated funds from the business because each new local market requires new local content to become relevant and increase market penetration. As a result, Netflix has tapped into debt markets to fuel the growth and thereby significantly increasing the debt leverage on the balance sheet (see chart). This could become a problem if refinancing terms change or growth slows down. Netflix is still a fascinating company but there are growing concerns over whether company is sacrificing margin for growth with hidden risks increasing.