As of the close of November 22nd the S&P 500 is +2.4% MTD and +24% YTD, and the MSCI World is +1.67% and +19.2% YTD.
- As we said last month, it feels that the equity markets, led by the S&P 500, just wants to grind higher against a lot of skepticism. While the narrative has been much of the same on US/China it continues to seem more conciliatory on the margin. While impeachment in the US and the election are making a lot of noise in the background, it seems the market isn’t going to wait that far out—at least for now.
- The market remains resilient—caught between this notion of waiting and hoping. Despite three consecutive down days last week (first time this happened in 2 months), the S&P ended November 22nd, at 3110, down only -0.5% on the week (in-line with MSCI World)—still just shy of all-time highs. Further evidence of this resilience was the Dow down only 100pts after Trump tweeted mid-week that we likely won’t get a trade resolution this year … probably if the same headline had been released 6 months ago, the market might have reacted quite differently—supporting the underlying resiliency of this market.
- In addition, better-than-feared 3Q earnings, and a cut to the Fed Funds Rate target range by 25bp, to 1.50-1.75% on October 30th, have all helped the equity markets higher this month.
- From an earnings perspective, 3Q results on the whole have been good—not great—yet the market continues to hold. Is it already discounting that we’ve seen the trough? The way this market is acting, it seems like it is. The problem is you need some of this good news to actually happen and trickle its way into economic growth and subsequently earnings growth.
- Regarding style rotation, MTD to November 22nd, the Russell 2000 Growth is +2.8% (and +21.3% YTD) and the Russell 2000 Value is +0.6% (and +14.2% YTD), reversing the more even behavior of these two indices of the past months.
- Powell’s testimony to Congress, November 13th, turned out to be a non-event and reinforced the ‘Goldilocks’ narrative from the Fed. He largely reiterated his comments after the October rate cut—current framework is appropriate…risks remain…and no change expected as long as the economy remains consistent with their outlook.
- Bottom line—Powell didn’t move the needle, and once again we believe the ‘Don’t Fight the Fed’ mantra and climbing the ‘Wall of Worry’ are the reasons for why we stand at the levels we do today.
- Our feeling is that now investors want to stay invested heading into the holidays, with the Fed protecting the downside. This is the exact opposite of this time last year where liquidity was drying up and we were heading into a rate hike, and the market was imploding.
- The US payroll report for October and nonmanufacturing ISM affirmed that imminent recession risks were muted. Nonfarm payrolls rose by 128,000 in October, exceeding the estimate of 75,000. There were big revisions of past numbers as well. August’s initial 168,000 payrolls addition was revised up to 219,000, while September’s jumped from 136,000 to 180,000. The unemployment rate ticked slightly higher to 3.6% from 3.5%, still near the lowest in 50 years. Finally, the pace of average hourly earnings picked up a bit, rising 0.1% to a year-over-year 3% gain.
- Other data last week also supported sentiment. US preliminary PMIs have inflected higher, alongside new orders, corroborating the bounce in business conditions Index. US Housing Starts and Existing Home Sales ticked higher, consistent with ongoing trends of better US housing data and the positive impact of lower interest rates, and the UMich print beat consensus with strong details on the consumer throughout. In Europe, there was also improvement to new orders and German manufacturing, although EU composite PMI remains in contraction territory.
- More broadly, it feels to us that there are still three debates going on in the market. We have alluded to these several times over the past few months…
- First, there are those that believe it’s best to own Growth/Quality, against a backdrop of anemic global growth and accommodative central banks. These investors (this has been our position) continue to deploy a Barbell-like approach—on one side they own expensive, high growth names, while on the other they balance this with names from more defensive cohorts—all the while avoiding cyclicals. For the most part (albeit with a few temporal rotations in recent months), this strategy has worked well in 2019, which likely incentivizes active managers to stick to the game plan so long as their view of the macro hasn’t changed drastically.
- Second, those that continue to worry about global growth prospects and risks to earnings, capex, and consumer confidence, and
- Third, those that are positioning for the reflationary trade in the event of a sharp inflection in the global economy. What would it take for the latter to play out? In order for Cyclicals and Value to sustainably work / attract flows, hard data would need to start inflecting higher, similar to what soft indicators (EA PMI new orders, Caixin PMI, EA ZEW, US Markit PMI) have already done. It is still to be seen exactly what course all of these trends will take, but for the most part, we would argue that investors are feeling significantly more at ease with the current environment vs. 6 months ago—and certainly vs. a year ago.
- Bigger picture, though, it seems to us that every discussion ultimately revolves around three key debates 1) resolution of trade, 2) where we are in the cycle, and 3) the global growth debate.
- Last week (November 20th) we circulated the Morgan Stanley (MS) 2020 outlook. In the case of the MS Global Economists forecast, global growth will improve from 1Q20 onwards, reaching 3.2% by year end, as compared to an estimated 3.0% in 2019. Given their team’s expectations of a 1Q20 growth recovery, they’d expect to see an inflection in high frequency indicators, like PMIs and trade, in the coming 2-3 months. They see both trade tensions and policy easing moving in the right direction for the first time in seven quarters, helping to support the global economy. However, it is worthwhile to mention risks still remain skewed to the downside, with uncertainty related to macro policies likely to linger. Conclusion from the MS 2020 Global Macro Outlook: The late-cycle expansion extends. 2020 will be a year of mini-cycle recovery in the context of a late-cycle expansion.
- MS Global Strategists are also focused on bottoming growth and high valuations leading to range-bound markets but larger reversals in leadership. MS Strategists believe the sequencing of this modest recovery is key to where these reversals lie. Similar risk-adjusted expected returns keep allocations clustered around neutral: Equities (-1%), rates (0%), credit (-2%), commodities (-1%), cash (+4%). MS Strategists prefer value over growth and Ex US exposure over US Equities, treasuries over gilts, European IG over US HY, and copper over oil and gold.
- Central banks are easing financial conditions globally. An improvement in growth could change that trajectory, investor sentiment and markets can turn faster than central banks can turn more hawkish. We remain constructive on the US equity markets and do not believe that we are in a similar situation as this time last year.
As of the close of November 22nd the Eurostoxx is +2.3% MTD and +22.9% YTD, and the MSCI Europe is +1.8% and +19% YTD.
- As far as earnings in the region…Europe's reporting season is now coming to a close, and the region has delivered a net earnings beat with 37% of companies beating EPS estimates by 5% or more vs. 28% missing. However, this again has been a low quality beat as it is largely reflecting the leg lower in consensus expectations (EPS estimates were downgraded on average by 4% in the two months prior to results season). These results imply a third consecutive quarter of negative EPS growth and suggest that weighted earnings across MSCI Europe have fallen by -5.1% year on year in 3Q. This figure, though negative, is an improvement on the early trajectory expected at the start of reporting season.
- As mentioned earlier, there was also improvement to new orders and German manufacturing, although EU composite PMI remains in contraction territory.
Asia and Emerging Markets
As of the close of November 22nd the Topix is +1.46% MTD and +13.2% YTD, the MSCI Asia ex-Japan is +0.44% MTD and +8.67% YTD, and the MSCI Emerging Mkts. is +0.63% MTD and +8.57 YTD.
These later two indices are still down from their peak on March 30th, 2019.
In addition both the Topix and the MSCI Asia ex-Japan are still down respectively since the end of 2017.
- This month China economic data was weak across the board with Industrial Production, Retail Sales, and Fixed Asset Investment all missing estimates.
- Japan’s GDP also had a big miss at .2% (vs .9% expected) and down from 1.8% last quarter. That said, it seems as though the market chose to look through this negative data out of Asia, as well as a US PPI number for October that surprised to the downside vs. cons expectations.
- On the other hand, there are bright spots in Asia. Japan is benefiting from both a cyclical upturn in the tech supply chain while also being a value trade due to low positioning. TOPIX is up 15% since the August low. Japan TSE weekly data confirmed the 4th consecutive week of foreign inflows at a cash level ($4.5bn). Taiwan is also experiencing re-engagement (+1.8% MTD and +19% YTD), with the foreign buying month-to-date run-rate now at $2bn thanks to inflows into names like Hon Hai Precision (2317 TT); +13% MTD and +29% YTD.
- It is hard to avoid the tensions in Hong Kong getting really worse. The HSI and HSCEI indices have almost erased all their YTD gains and are now only up 2-3%. One of the most hit sectors is Property, with the HSP Index down 8% last week. The MSCI HK has underperformed MSCI AxJ by 10-12% this year, and is now valued at 10.4x forward P/E.
Currencies and Commodities
- In currencies - The USD strengthened slightly to around 1.102 against the EUR. Even with the tariff turmoil the currency markets have remained extremely stable.
- In commodities – A run of record and multiyear highs across equity markets reflects faith in a cyclical rebound over the coming months, loaded with hope for a rise in profits and lighter margin pressures. But commodity markets do not concur. Industrial metals have produced a less effusive performance with renewed declines in copper prices (-1.84% YTD), a barometer of future economic activity. Oil prices are facing a rising tide of supply and telling a story of less than stellar demand in the future, however MTD WTI and Brent are up +6.6% and +5.3% MTD respectively and +27% and +18% YTD.
- Gold has continued to correct in November to $1,461 an ounce, -3.4% MTD and +14% YTD.
- In US Fixed income - The yield curve has continued to change shape since the extreme rally in the beginning of the month of September. With Fed Fund rates at 1.75% (after the cut of 0.25 at the end of October), current 2 year rates are at 1.63%, 5 year rates at 1.62% and 10 year at 1.77%, slightly lower than in the earlier part of this month, when 10 year rates tried to break higher and touched 1.9%. The yield curve has steepened in the medium to longer part of the curve.
- In European Fixed income – the yield of Germany’s benchmark 2-year bond is -0.64% and the 10-year, is now -0.36%. As in other fixed income markets rates in Germany are slightly lower than earlier in the month and pretty much unchanged since the last IC. Weak German growth data, remain the main driver for negative interest rates in Europe.
- The expansion of negative yielding debt, and indeed its acceptance as part of the current financial system, compounds the asset allocation problems facing investors in the future. Above all, it heightens the worry that a major accident could be around the corner. An entrenched world of negative yields upends the important role played by government bonds in providing insurance or ballast for portfolios that generally favor equities and credit.
- As fixed-rate coupons disappear, and as bond investors rely ever more on price appreciation to hit return targets, holding bonds becomes little different from holding stocks. The distorting influence of negative yields across global fixed income has emerged in recent years as central banks have become major holders of bonds as they try to boost economic growth and inflation. But such activities have failed to offset long-term trends depressing bond yields such as ageing populations and rapid technological change, which respectively boost savings rates and dampen inflationary pressure.
- This means that holders of bonds with low and negative yields are painfully exposed to even a modest rebound in growth and inflation expectations, which should naturally cause yields to rise. But as the global economy feels a squeeze on manufacturing and waits for signs of a genuine truce in the US-China trade war, bond prices, for now, reflect expectations of weaker growth and the hope that central banks will repeat their previous doses of extraordinary monetary policy.
- The investment outlook for 2020 that we are centering on are dominated by common themes already discussed: political noise on trade and the US election cycle, the resilience of leading economies, switches between value and growth, relative allure of the US equity markets and cheaper rivals such as emerging markets and Japan. However, most probably earnings and the business cycle are the most likely drivers of equity market performance in 2020. A run of record and multiyear highs across equity markets reflects faith in a cyclical rebound over the coming months, together with hope for a rise in profits and lighter margin pressures.
- This month, 10 year government bond yields and inflation expectations tried to break higher on the prospect of a bounce in the global economy, but that proved short-lived.
- There is a sense that the push for greater fiscal stimulus in 2020 faces higher barrier, limiting the scope for a stronger economic recovery from here.
- We need to figure out which signals to believe, and must understand the feedback loops. Rallying equities could reflect either expectations of an economic bounce or the valuation boost from a supportive backdrop of low bond yields and central bank stimulus.
- The story for investors this year has been the reverse of what they experienced during 2018 and revolves very much around the level of the 10 year government bond yields. Rising yields in 2018 crushed equity multiples, while this year, share markets have bounced back as benchmarks substantially reversed course.
- In summary, a tough year for the global economy stands in contrast with a robust performance for global equities.
- A question for equity buyers in 2020, therefore is whether profit growth and margins improve in the coming 12 months, and to what degree. One risk is that earnings could deteriorate even if the global economy picks from its slumber. That would really challenge generous equity valuations and risky assets, and throw the balance of monetary policy and equities into question.
- Conclusion – in a world of contained sovereign yields and accommodative central banks we still favour equities for generating returns.
- Asset class implications – Swings in sentiment expressed in the news are becoming quite sharp; they have retreated from the optimism of the IC at the end of April, when the S&P 500 made new highs, to a much more pessimistic tone in May, to a more optimistic scenario in September, October and November. Since the end of August (23/8/2019) the S&P 500 and the MSCI World are up +9.2% and +8.6% respectively.
- The more dovish tenor of the Fed underscores the expected support that monetary policy is providing the economy and markets this year. The countervailing pricing of growth and policy is a recipe for continued volatility around a muted equity market trend in the coming months. In contrast, sources of carry, like credit, make more sense on a risk adjusted basis (except if we enter a recession).
- We continue to overweight U.S. equities over the rest of the world. The view that cyclical/value stocks could outperform growth shares, is becoming more and more compelling, and that is why we have reinforced our position in the Russell 2000 Value. It seems to us that the S&P could absorb a lot of the good news on trade, if and when it occurs, as well as further interest rates cuts.
- Europe, Japan and emerging markets are still in the shadow of potential future trade disputes, and less margin for monetary stimulus. However we clearly prefer Europe over Japan and EM equities, and that is why we increased our European equity position last month through the ODDO BHF Avenir Europe fund (+2.74 % MTD and +25.6% YTD).
- We remain cautious on duration – prefer short duration fixed income instruments. We believe long duration can be extremely painful if the curve moves higher and steeper, as the sensitivity of longer duration fixed income assets will be extremely high.
- Bonds may be telling a more gloomy story than the equity markets. So who should we believe ? We would acknowledge that it is becoming harder to balance the marginally more positive tone being set by economic data and stabilizing earnings against the clear tail risks arising from trade tensions and geopolitics in general. Harder still is filtering out the more extreme expressions of optimism or pessimism that nowadays seem to accompany relatively small shifts in price action. Absent a further escalation in trade tensions (Trump cannot sacrifice his election prospects by creating a recession), the backdrop of stable, trend-like growth will eventually regain primacy. And with it, the volume of those voices suggesting a “melt up” in asset prices may well rise again. But looking beyond the fear and greed that tends to fuel sentiment, the fact is that the global economy remains in late cycle.
- In this environment, we continue to believe that credit can perform. A diversified exposure to credit, like we have, should be maintained. We do see a better outlook for equities at the margin, with negative news already priced in equity prices, earnings revisions trending a little better and expectations for the rest of 2019 and the early part of 2020 now quite achievable. Nevertheless, the level of headline risk associated with the prevailing trade rhetoric leaves us in no hurry to rush into a large equity position.