Equity Monthly: Is Sweden signaling spillover into services?

Another concern that investors should take note of is equity valuations. S&P 500 is now seeing a valuation that is the highest since 2001 (excluding the Jan 2018 observation) highlighting stretched market conditions and lower implied expected returns. Based on the current valuation level in the S&P 500 we observe historically a 0.5% real return annualized with a +/- 2%-points uncertainty. This means that investors buying into current valuation levels are pursuing momentum effects rather than long-term return expectations. These moves never end good.

But the central question for investors should be whether yesterday’s weak Swedish PMI Services print for November at 47.9 is a sign of emerging spillover effects into the broader economy. If Sweden leads Europe and potentially the US due to its pro-cyclical characteristics then yesterday’s print is ugly reading for investors. Sweden’s economy is approaching activity levels not observed since the euro area crisis in 2012. If the spillover effects from the manufacturing recession are real and growing then the global economy will be hurt badly. Policy rates are already low providing little firepower for central banks so fiscal will have to take over to reverse the bleeding. But fiscal moves slower and is certainly behind the curve in many countries, most notably Europe, which means macro weakness in 2020 could be worse than most think today. Watch Sweden is our only message in this monthly equity update.

As we have argued many times recently negative rates have hit the end of the road. It’s clearly not strengthening the credit channels and the banking sector business model is not working on the current monetary policies. In our view, led by the Riksbank, ECB will begin next year to forward guide markets about lifting rates regardless of the macro outlook in order to soft pressure Europe’s government to do more and create a better “policy mix” using ECB president Lagarde’s own words.

When we look across the economic landscape it’s clear that the UK and Europe have the most room for maneuvering on the fiscal side with especially Europe running too tight budgets relative to the current trajectory of the global economy. But here lies also the upside potential for next year. European equity markets could be the big surprise next year if both the UK and EU loosens the purse string as it could drive stronger currency and ultimately demand. If the ECB in addition indicates a shift in its monetary policy then banks would significantly add to performance. Also note today's decision by the Japanese government to launch a $121bn stimulus programme to revive growth. It's already starting.

Semiconductors stocks have done very well despite challenging trade environment as demand has remained robust and some frontloading by China has likely taken place. We like to use South Korea and semiconductors as leading indicators on the economy. Numbers out of South Korea are still worsening and the trade uncertainty is holding back investments among many companies. The hesitation to do investments are beginning to feed through to the semiconductor industry with operating earnings showing the biggest drawdown since 2012. Semiconductor earnings doubled from late 2016 to late 2018 which has fueled strong sentiment. Our view is that a lot of the hype around AI will cool down significantly in 2020 and with it demand for semiconductors.