Head of Equity Strategy
Summary: Equities continue to defy logic as global equities are well within their all-time highs despite economic softness and recession risk remaining elevated globally. What will it take for equities to reflect reality? The next big test is the Q3 earnings season starting in two weeks. We expect earnings to disappoint against expectations and that global earnings growth will go negative in Q4. We also expect US-China negotiations to lead to nothing in October and thus worsening the trade war dynamics and their impact on the global economy and financial markets.
September has been a month of surprises. Despite recession risks remain elevated with the US economy having an estimated probability of around 40% to be in a recession within 6-12 months, US equities are well within their all-time highs and the MSCI World All-Country Index was up 1.7% in September. The marginal buyer of equities is still confident enough to keep up risk and one must wonder what it will take for equities to experience a meaningful setback? The four main catalysts all linked together is global economic recession, negative earnings surprises and outlook, US-China trade war escalation and USD liquidity.
In two weeks the Q3 earnings season starts with expectations remaining high despite clear indications that earnings growth is headed lower. Global EBITDA growth y/y (see chart) is down to 2% which is the lowest since late 2016 and given the autocorrelation structure in earnings growth we expect earnings growth to go negative in the fourth quarter. This could prove to shake sentiment among the confident equity investors.
This month also gave investors something else to worry about. The general collateral repo rate in the US suddenly spiked and the Fed had to eventually step in with repo operations to stabilize this overnight lending rate. Many explanations were presented for why the spike happened with technical aspects such as corporate tax payments overlapped with large Treasury auctions. But the sustained pressure on the repo rate forced the Fed to begin two-week repo operations and former Fed president Narayana Kocherlakota recently raised concerns about dynamics unfolding in the repo market.
One of the root causes behind the repo rate spike is post financial crisis regulation forcing banks to hold more liquid assets on their balance sheet and a prohibitively charge on balance sheet. This regulation forces banks to utilize and optimize their balance sheets to a degree where they cannot easily commit risk capital in a market segment to arbitrage away inefficiencies or capture an opportunity. The four largest US commercial banks also have increased their balance sheets to a degree where they will all see a surcharge by Q4 if they don’t reduce their balance sheets. In effect US banks are incentivized through regulation to reduce balance sheet which will constrain USD liquidity even more.
In our upcoming Q4 Outlook this week we analyse the USD and what it means for asset classes and the economy. The overall conclusion is the USD strength is killing global growth and with monetary policy maxed out the next policy move will have to be that of weakening the USD. Part of that exercise is to cut USD rates more aggressively and also begin expanding the Fed’s balance sheet which has been shrinking since late 2017 (see chart).
On Friday the US-China trade war took another turn even before the next round of trade negotiations set for October 10-11 in the US. Reports suggested that the White House is looking into how to restrict China’s access in US capital market which could include delisting Chinese stocks in the US and limiting investment firms to invest in Chinese stocks. The report’s conclusions were denied by the Treasury department, but all investors should recognise that such claims of potential future policy moves do not arise in vacuum. Inside the US government there is likely an active discussion on how to regulate Chinese companies listing the US. The news reinforces our view that there will not be any comprehensive deal between the US and China anytime soon.
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