Market summary

February 28th, 2019



As of the close of February 25th the S&P 500 is up +11.4% YTD and the MSCI World up +10% YTD.


  • The irony of where we are today versus how we finished last year, is rather puzzling to say the least. If you decided to take a vacation for all of December and ignored the markets until January, you probably would not think much has changed—investors still generally own what they have owned, just with lower exposures. The speed and magnitude of the collapse and recovery in stocks since early December has been highly exceptional. For the S&P 500, December 2018 was the worst month performance-wise since 1931, while we started 2019 with the best January since 1987—5th best all-time.


  • The remarkable rebound in the U.S. stock market from the lows in late December has resulted in gains that analysts rightly point out already constitute banner returns for an entire calendar year. History is replete with examples of major recoveries following big sell-offs, many of which turn out to be head fakes otherwise known as bear market rallies. At the end, it is still fundamentals that should drive investing decisions.


  • If the economy is, in fact, slowing and that is what has sidelined the Federal Reserve, then what we are witnessing at the moment is probably a bear market rally. Even though the January employment jobs report might have looked good on paper with 304,000 jobs created, it nevertheless flashed a bright recession signal as the unemployment rate ticked up to 4 percent, the highest since June. According to historic payroll data and the National Bureau of Economic Research, every time the three-month average unemployment rate exceeded its six-month average at cycle peaks over the past 50 years -- like it did in January -- the U.S. economy has experienced a recession.


  • Backing out to the broader economy, one of the fastest growing reasons for increased layoffs last year was mergers and acquisitions. There's likely to be no change in 2019 after last year’s record M&A activity, which is just one of the more creative avenues companies have pursued to reduce costs in recent years. The looming earnings recession will compel firms to be more direct in their approach, as in outright headcount reduction to protect profit margins. Auto dealers are struggling to shoulder the weight of the most crowded lots in almost two years. As a result, auto production contracted in January, promising to pressure Midwest manufacturing, a stand out area of the economy in recent months as other regions faltered. As is the case with the earnings sudden stop, motor vehicle and parts swung from 8.4 percent year-on-year growth in December to a 0.7 percent contraction in January, according to Industrial production data from the Fed. Although autos were a sweet spot in the delayed December retail sales release, that strength appears to be wavering as cumulative tax refunds disappoint. In the first 18 days of the tax season through Feb. 21, cumulative refunds totaled $36.3 billion, down $61.7 billion, or 63 percent, from the same period last year. This portends poorly for the seasonal surge in auto buying and consumer spending tied to households’ propensity to spend the majority of their tax refund proceeds. If anything, Fed data show households are hunkering down, with checking and savings account balances rising dramatically, moves generally associated with spending pullbacks.


  • Markets seem to be trading on an illusion of ample liquidity, with volatility at subdued levels, gold prices trading up despite the USD remaining within a tight trading range, and equities breaking higher as the bond market treads water. All of this is happening as the Fed continues to shrink its balance sheet. After a decade of easy money in a post-global financial crisis world, for a Fed that turned hawkish just to flip and revert back to patience, we ask ourselves what is next? The Fed minutes from February 20th, highlighted the important role of the recent deceleration in core inflation in moving the FOMC away from further rate hikes. It seems clear that it will take a significant turn in the inflation picture to move them back into rate hike mode, a main point of support for the market.


  • As we know, the market is a discounting mechanism, so the question has now become: what is priced in? While we appear to be out of the woods as far as another US government shutdown goes, there are still several overhangs that the market appears to be pricing for positive outcomes (i.e. Brexit, trade tensions, global growth). It feels we are back again in a ‘Goldilocks’ narrative, that many investors experienced in 2017 and have warmed up to in 2019, however the durability of this narrative is particularly concerning.


  •  Amidst all this, and being mindful of the market technical, one can observe the following : on December 24th, only 1% of stocks in the S&P closed above their 50-day moving average — one of the most extreme oversold levels in history. Now, after a broad rally over the last eight weeks, that number now stands at 92% — one of the most extreme overbought levels in history. Following the rally off December lows, MSCI AC World (in local currency terms) has retraced close to three-quarters of the sell-off since September, trading above its 200-day moving average. And yet, while many tactical indicators are now looking quite elevated, positioning data looks much less extended and suggestive of a lack of participation in the recent rally. Arguably, there is not that much to sell as barely any risk has been added year to date. Following certain long / short strategies, gross exposure is up 3% at 161% and net up 3% to 46% net long. After the best January for the S&P 500 in more than three decades, net exposure for hedge funds hasn’t budged from near record lows. According to Morgan Stanley Prime Broker data, European equity L/S net exposure is in the 5th percentile dating back to 2010, and even inthe US, net exposure is still only in the 13th percentile.


  • In the five months through August 1989, the S&P 500 rallied 19.2% before backsliding. Other periods include the following ones:


table 1


  • Thus, in an environment where investor exposure is this light, we are of the view that idiosyncratic opportunities are what truly matter. From the lows in December, the market has rewarded beta almost indiscriminately--the greater the beta, the greater the performance. It is almost the exact opposite of last year's rolling bear market during which the higher beta securities were hit first and the hardest. Cyclicals and expensive growth stocks are high beta and both have performed well year to date in what has been a broad beta rally. As such, both are now vulnerable to a market correction should we have one.


  • Of the notable idiosyncratic stories in the US last week was Kraft Heinz Co (KHC). After the company’s weak earnings and guidance the stock was down ~27%. Many analysts are most negative on KHC’s ability to deliver an inflection in revenue, while simultaneously expanding margins—both of which came into question in the company’s FY18 results.


  • In a world where economic data continues to give mixed signals, it is interesting to see cyclicals outperform. Notably, the cyclical / defensive dispersion ratio is in the 99th percentile since Jan 2018, as dispersion within defensives has fallen, while dispersion within cyclicals has risen. It is worth highlighting that certain strategists have recently turned bullish copper and that copper prices hit a seven month peak on Wednesday last week. The potential upside to copper prices is derived from the expected supply-driven deficit by year-end.


  • Regarding our views between the “rest of the world” over the US, while Europe, Japan and EMs, meaningfully underperformed in 2018, since November, we have seen a subtle, but noticeable shift, especially within EM, as China and Asia have quickly re-rated. The MSCI EM, +9.6% YTD, with Brazil +15% and China (CSI 300) +27% YTD in dollar terms. These moves support our view to remain bullish EMs towards the end of last year, which we believe is well-positioned to benefit from narrowing growth differentials, a weaker USD, and attractive valuations.


  • We have remained over weight China.  The logic remains that the policy easing cycle will again prove sufficient to lift underlying economic and earnings growth momentum. The record-high January total social financing of Rmb4.64trn (cons. Rmb3.3trn) represented 11.4% YoY growth versus 10.6% in December and shows monetary easing is starting to translate into credit growth. In the face of this, one could be asking oneself whether China positioning has swung to the extremes and if it’s too late to participate at this point. The case can still be made we have more room to go. The country’s EPS revisions ratio relative to ACWI has moved from a 10-year low in November back into positive territory for the first time in a year. And as an additional support, retail investors, which make up 70-80% of the A-share market by transaction volumes, are only just starting to jump in and should provide liquidity to drive the markets.
Sources: Global Reflections, by Nick Savone, Morgan Stanley, February 23rd, 2019 and How to Identify a Bear Market Rally, by Danielle DiMartino Booth, February ‎24, ‎2019‎.





  • Yet, in Europe more broadly it is clear that there is no investor FOMO (fear of missing out), which could not be more obvious lately. There was a lot of promise and expectation for European growth at the start of 2018. Fueled by easy financial conditions and falling unemployment, the recovery looked to be finally finding its feet. However, since then, European economic data has deteriorated significantly. As this weakness has persisted, investors have become tired of the seemingly perpetual excuses for weak data, and sentiment towards European assets has worsened. With few domestic catalysts for a turnaround, it may take a rebound in demand from the emerging world to improve prospects for the region. Looking at the detail of the slowdown, it appears that much of the weakness can be attributed to net exports. Net exports contributed 1,4 percentage points to the annual real GDP growth rate in the fourth quarter of 2017, but in the third quarter of 2018 their contribution was negative. Both sides of the equation—imports and exports—contributed to the deterioration, as the rising oil price in the first three quarters of 2018 led to a sharp increase in imports, while at the same time export growth stalled. Given that exports make up approximately half of GDP in the Eurozone, a slowdown in global growth was always going to prove a strong headwind. In particular, demand from emerging markets has softened. In November, exports to Turkey contracted by one-third YoY due to the confidence crisis that led to a slowdown in growth and the devaluation in the currency, while export growth to Asia slowed because of a slowing Chinese economy.


  • But external factors aren’t the only ones to blame: domestic factors have played their part too. In Italy, the new coalition government’s dispute with the European Commission over its proposed budget sent borrowing costs to multi-year highs and tightened credit conditions. The prolonged period of political uncertainty has taken its toll on the Italian economy, with the country technically falling into recession. In France, the protests of the “gilets jaunes” (a movement focused on social inequality) have caused significant disruption, sending the French composite purchasing managers’ index into contractionary territory at the end of 2018. Impetus in the protests now seems Impetus in the protests now seems to be waning and growth data for the fourth quarter of 2018 held up surprisingly well. But populism remains a risk across Europe, with the European Parliament elections in May likely to show that Eurosceptic parties still garner significant support. In Germany, the autos industry has struggled to get to grips with the new emissions testing regulations, hampering industrial production and dragging significantly on growth. After a difficult fourth quarter of 2018, German auto production now looks to be picking back up, which could be a near-term boost to growth.


  • Monetary policy looks set to remain accommodative in 2019, which will keep lending rates at a very supportive level. The European Central Bank (ECB) reiterated its forward guidance on interest rates in January, and also acknowledged that the risks to the outlook had moved to the downside. Beyond this liquidity provision, the ECB’s ability to stimulate the economy further is limited. Key interest rates are already in negative territory. The ECB will struggle to expand quantitative easing as it is nearing the upper limit of the amount of German Bunds it is permitted to buy. Parameters would have to shift to allow it either to buy a larger proportion of the German market, or more debt from other countries—a politically contentious issue.


  • Last week we saw positive macro data out of Europe with the Composite PMI surprising to the upside, rising from 51 in January to 51.4 in February, the first sequential rise in six months. Add to that, tactical indicators have been looking quite elevated and Europe has rallied 12% from December lows. The MSCI Europe is +9.8% YTD. And yet, European Hedge Fund net exposure has barely moved, having risen from a low of 21% to just 25% today. Bottom line, investors are looking for significant outperformance in Europe to dip their toes back in. Some strategists we follow believe FCF Yield (free cash flow yield) is king when screening for opportunities in Europe. FCF Yield has a very high long term efficacy, strong performance (when the economic cycle is in recession) and is now the cheapest it has ever been.


  • Eurozone stocks may perform better than the economy. The multitude of elements that have contributed to a slowdown in Europe, coupled with the absence of a clear catalyst for a turnaround, has left investors cautious of investing in the region. But it is worth remembering that approximately 50% of European corporate revenues come from outside the region. In 2018, the European macroeconomic environment continued to deteriorate, but companies were still able to achieve a respectable 5% earnings growth. An uncertain economic outlook for the region suggests investors should remain cautious in the near term. But the international nature of European companies and the broader Eurozone economy means that the direction of the global growth environment will have a large bearing on future performance. Investors will likely stay on the sidelines in Europe until we get the promise of a lasting recovery in growth. But were the macro data to improve, we could see a change in fortunes for European stocks given a lot of bad news is in the price.


  • With limited help available to the Eurozone economy from within, an improvement in external factors might prove the key for a turnaround in sentiment among both manufacturers and consumers. The necessary catalyst for a change in economic momentum could also come from the avoidance of a hard Brexit, a de-escalation in trade tensions or a soft landing in China. While the first two carry the uncertainties of politics, we have a larger degree of confidence in the latter as China continues to ease monetary and fiscal policy to stimulate its economy. In January, the People’s Bank of China cut its Reserve Requirement Ratio by a further 100 basis points, injecting a net figure of RMB 800 billion (0,8% of nominal GDP) into the Chinese economy. New infrastructure projects have also boosted investment growth, and Beijing continues to implement tax cuts for corporates and consumers alike.
Sources: Global Reflections, by Nick Savone, Morgan Stanley, February 23rd, 2019 and How to Identify a Bear Market Rally, by Danielle DiMartino Booth, February ‎24, ‎2019‎.


Market Summary