As of the close of October 25th the S&P 500 is +1.54% MTD and +20.6% YTD, and the MSCI World is +1.95% and +18% YTD.
- October has been a less eventful month with more positive news coming from the trade front. The S&P has finally broken through the 3,000 level (3,022 on October 25th), and globally, stocks have closed near record highs on US-China trade optimism amid improving headlines and better-than-feared 3Q earnings, with the Fed expected to cut rates this week, on Wednesday October 30th. We expect the FOMC to cut the Fed Funds Rate target range by 25bp, to 1.50-1.75%, with assurances that it "will act as appropriate to sustain the expansion”, as it has stated in the recent past.
- It feels that the equity markets, led by the S&P 500, just wants to grind higher against a lot of skepticism. The catalysts for the recent move higher have been consistent. While the narrative has been much of the same on US/China and Brexit, it continues to seem more conciliatory on the margin. As for Brexit, while the saga continues, it feels that it is moving in the right direction. 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.
- 3Q earnings continue to come in better than expected after last week of 3Q earnings releases in the US. On the earnings front, nearly ~50% of the S&P 500’s market cap has now reported, with 76% of companies posting beats. As a reference, the historical average for the percentage of companies beating earnings estimates is 68% since 2004. The number of companies beating on topline results is lower than the absolute earnings beats, with 60% of companies beating sales estimates. Across the S&P 500, the average company is beating earnings estimates by a margin of 4.4% and sales forecasts by a margin of approximately 1.2%.
- Tactically, many measures of investor risk-aversion have become much less cautious in the last two weeks. Yet, many skeptical strategists continue to think caution is warranted. The ‘bear camp’ focus on a variety of cyclical indicators that historically point to poor returns over the next 12-24 months. Others are more optimistic and focus on 1) economic momentum and PMIs that could be set to inflect, and 2) already cautious economic sentiment meaning that implies growth concerns are already in the price.
- 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.
- The battle between Cyclicals and Defensives has continued this month. As well as Growth versus Value. Rotation continued to be the dominant source of volatility in the market. One of the major factors providing support has been that P/Ls have been strong this year, providing a ‘performance cushion’ that keeps investors and traders from being forced to unwind. But performance of some of the most extreme examples of crowded trades suggests that pressure could be increasing—Growth Software and SaaS are down 20 to 25% from July peaks relative to the market. Given how little is priced into cyclicals, any improvement in growth, a weaker USD, or a Brexit or trade deal could be catalysts for this unwind to accelerate.
- MTD the Russell 2000 Growth is +2.15% (and +17.2% YTD) and the Russell 2000 Value is +2.5% (and +13.76% YTD). Clearly Value has strongly rebounded both in September and October.
- More broadly, it feels that there are three debates currently going on within the market.
- The first is those in the camp that believe it’s best to own Growth/Quality. These investors (we have been in this camp) continue to deploy a barbell-like approach against a backdrop of anemic global growth and easing central banks around the world doing what they can to support both the global economy/markets. On one side they own expensive, high growth names, while on the other they balance this with names from more defensive ones — all the while avoiding cyclicals. This has worked so far YTD (however not as much recently), which likely incentivizes active managers to stick to the game plan so long as their view of the macro hasn’t changed drastically.
- Then there is the view of certain who remain underweight equities, with strategists seeing scope for a cyclical bear market given continued risks to earnings, capex, consumer confidence, and economic growth. In this case, these see the high growth names on the barbell (i.e. high growth SaaS, semis, tech hardware, etc) underperforming significantly, relative to the more defensive ones of the market (i.e. Consumer Staples & Utilities). While 3Q earnings have been positive thus far… these strategists believe that there is still a way to go this season.
- The third debate is perhaps the most interesting. This is the “What If We Are All Wrong,” scenario and the world isn’t as bad as it seems… leading to be positioned long the risk-on, reflationary trade. In this case one should be ‘playing for the unwind’ of the consensus ‘flight to quality’ and it appears to be the most convex trade in the market today. We are tempted to believe in this scenario.
- 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 October 28nth the Eurostoxx is +1.4% MTD and +20.6% YTD, and the MSCI Europe is +1.1% and +17.3% YTD.
- The question many global equity investors are asking themselves; is it time to buy into Europe? There’s a concern the presidential election makes US volatile and hard to invest in next year, while Europe could see a triple positive from end of trade wars (seen as affecting Europe more than other regions), Brexit resolution, and ECB / Germany moving from monetary to fiscal policy or government spending. It seems like European interest seems to be picking up again off a very low base, and it doesn’t hurt that earnings season has been faring reasonably well so far with 32% of companies tracked so far having beaten EPS estimates vs. 22% missed, giving a net beat of 10%.
- Continuing with the European upbeat tone, as Brexit uncertainties start to clear up, UK Mid and Small caps could have at least a +10% upside, given they are up a mere 2% YTD, and offer one of the most attractive risk-reward. While a reduction in Brexit uncertainty is good news for UK and European equity markets in general this change provides further fuel to the tentative style rotation that has taken place over the last couple of months – i.e. the reduction of Brexit uncertainty is likely to be even better news for Value stocks.
Asia and Emerging Markets
As of the close of October 28th the Topix is +3.8% MTD and +10.3% YTD, the MSCI Asia ex-Japan is +3.2% MTD and +6.9% YTD, and the MSCI Emerging Mkts. is +3.48% MTD and +7.25 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 -10% and -8% respectively since the end of 2017.
- In Japan broadly, we have continued to see a strong rally due to the recent ‘value bid’ and USDJPY stability around 108. Japan remains Morgan Stanley Research’s top equity market globally and foreign ownership has only just started to see inflows again last week.
Currencies and commodities
- In currencies - The USD weakened slightly to around 1.1100 against the EUR. Even with the tariff turmoil the currency markets have remained extremely stable.
- In commodities – After strongly reacting to the bombing of Saudi Arabian oil facilities installations by what appeared to have been an attack by 18 drones and seven cruise missiles, on September 14th. both WTI and Brent are +5.2% and +2.5% MTD in October (they do remain +25% and +16% YTD, respectively). Recent US inventory numbers have surprised to the downside, giving a more positive tone to WTI. Other markets like Gold is unchanged in the past months (above $1,500) and +16.5% 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 2% (but expected to be cut this Wednesday to 1.75%, current 2 year rates are at 1.66%, 5 year rates at 1.67% and 10 year at 1.85% and 30 year at 2.33%. The yield curve has steepened in the medium to longer part of the curve.
- In European Fixed income – after the ECB decision earlier in the month, the yield on Germany’s benchmark 2-year bond is -0.66% and the 10-year, is now -0.34%, Weak German growth data, low inflation numbers and the continued belief that China weakness is bad for German growth, remain the main drivers 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. An interesting example of this happened this month when the UST 10 year bond lost 4% as rates moved from an extreme level of 1.46% earlier in the month to 1.9%, and then 1.7% now (-2% MTD).
- 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.
- 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 and October. The more dovish tenor of the Fed underscores the expected support that monetary policy could provide to 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. 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.
- For the reasons given before, 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. We do not want to make any fixed income duration bets when now over $16 trillion of sovereign credit is negative yielding.
- 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.
- Over the longer run, our base case remains that there will be some de-escalation of trade rhetoric, sufficient to calm markets. As a result, we expect the 4Q of 2019 to be characterized by trend-like, but weaker growth, easy policy, muted inflation and limited near-term risk of recession. And as the 2020 election campaign draws nearer, we would also anticipate a rather more reassuring tone for the economy and markets from the administration.
- 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 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.