Coronavirus uncertainty not priced in and US technology earnings superiority
Head of Equity Strategy
Summary: Taiwan equities resumed trading today down 5.7% on massive discounting of economic disruption from the coronavirus. We maintain a negative view on equities and investors should clearly avoid the industries mentioned yesterday such as cruise lines, cars, airlines, steel, oil & gas and miners. The FOMC clearly demonstrated that they are behind the curve yesterday and consensus is expecting two more cuts this year as the economic recovery is fragile and the USD is too strong. We also observe signs of inflation in Germany with CPI numbers jumping back close to 2%. In today's equity update we also take a look at the Q4 earnings season and zoom in on earnings releases from Tesla, Microsoft, Facebook and Boeing.
Equity markets in the developed world show a remarkable disconnect from the signals coming out of key commodity markets such as iron ore, oil and copper. Commodity prices are reflecting real economic impact on the ground in China and given the sparse real-time information coming out China related to the coronavirus our view is still to respect the unknowns and nonlinearities. The only equity market that showed some price discovery in Asia was Taiwan equities down 5.7% in an ugly session with continuous selling pressure through the entire session. Our main view is still to remain tactically short equities as we do not know the full impact of the coronavirus until in a couple of weeks. The key for equities is that if Chinese activity slows down significantly it could suddenly hurt the early and fragile recovery in the global economy.
The FOMC yesterday delivered nothing to the market but consensus is still expecting two more rate cuts this year as the yield curve is flattening again and the USD remains strong. The coronavirus could also force the FOMC to move soon as the CNY is weakening and investors are buying USD safe-haven assets.
In Europe several regional CPI surveys show that inflation has increased substantially in the past three months. With the UN Food and Agricultural World Food Prices Index at the highest levels since late 2014 it seems core inflationary pressure is building in the economy. As we have written about earlier this month the key risk to equities this year is more likely from inflation rather than a recession (that’s before the coronavirus emerged as a real threat) although the recession risk in the US is still around 32% over a 12-month horizon.
The earnings season is in full swing with 16% of the S&P 500 having reporting earnings. So far numbers are beating expectations in the US and the growth numbers are quite decent with strong performance from the IT and Communication sectors. The 12-month rolling S&P 500 EBITDA per share growth is 5.6% in a clear stabilization phase (European companies EBITDA growth is 3.5% in Q4) with only 1.2%-pts of the gain coming from share buybacks. This robust profit growth suggest that S&P 500 is still having a high equity risk premium relative to the historical average as interest rates remain low. The S&P 500 robustness on profit growth is related to the fact that the IT sector now accounts for 24% of the index and if you add the Media & Entertainment group then 32% of the S&P 500 Index is based off digital powerhouses extracting huge profits from strong global market positions. In some respect the S&P 500 is no longer representing the “true” state of the large US equity market.
Buybacks in the S&P 500 Index slowed down in the first three quarters of 2019 but it is clear that the fourth quarter has seen an acceleration again reflecting the large cash generation surplus from large US companies. The relentless buybacks and the quasi monopolies dominating the key US indices will continue to fuel equities. The improved company fundamentals in Europe since early 2017 are also beginning to show up in the index divisor for the STOXX 600 Index which fell 0.7% in 2019 in a sign that European companies are now in a negative net equity financing position. This should bode well for European equities.
As the regular reader will know we are overweight European equities with a more neutral position on US equities as the 6% equity risk premium on European stocks relative to 5.1% US equity risk premium is attractive and especially if the EU increases the fiscal deficits over the years to fund the green transformation.
Among the most interesting earnings releases we had a quarter from Tesla ending the fiscal year generating $1.1bn in free cash flow. Tesla shares closed at $648 in extended trading last night which undoubtedly will drive more short covering in Tesla with still 17.6% of float being shorted. While overall the Q4 result was strong the revenue numbers were disappointing for the second straight quarter so unless revenue growth kicks in again in 2020 then the growth story will be challenged by the market. The coronavirus also comes at a bad time for Tesla efforts to ramp up sales in China which is not being discounted at all in the stock price.
Boeing delivered another bad quarter as the company is handling the fallout from the 737 Max crisis. The company delivered negative $2.7bn in free cash flow on top of the almost negative $4bn free cash flow in the two previous quarters. Given the uncertain situation around Boeing estimates for 2020 almost seem too positive and we wonder whether the market is reflecting the downside risks still present.
Facebook delivered in Q4 against expectations but investors were still disappointed and the media was immediately ready with headlines such as “growth concerns” which we have seen before. Facebook still has the leading position in online advertising and still years ahead with high growth and monetization of other key assets such as Instagram.
Microsoft delivered 14% revenue growth in Q4 and net income rose a new record at $11.5bn with the cloud business driving the results. Microsoft has a 3.5% free cash flow yield and is expected to grow revenue at +10% annualized rate for the next couple of years as more corporate customers are shifting to the cloud business.
Overall the Q4 earnings from the US is a tale of technology companies delivering driving overall profit growth in the S&P 500.