As of the close of September 21rd the S&P 500 is +2% MTD and +19.4% YTD, and the MSCI World is +3.1% and +16.6% YTD.
After a volatile August, September has been a less eventful month … one of waiting. Waiting for the Fed, waiting for a resolution of the ongoing China/US trade war and waiting for a potential Brexit outcome. Equity markets have rallied this month and the focus will be the upcoming earnings season … more “wait and see”.
The September FOMC meeting was firmly in-line with expectations, as the Fed cut another 25bps (no real surprises there). The decision was followed by “a very non-committal press conference…uncertainties remain, with the Fed monitoring, and which will act as appropriate. Said otherwise, there is no pre-set course. Yes, the market wanted to see a tighter / set path, but markets were quickly calmed by the positive update on the Balance Sheet. All in all, the Fed managed to cut, leave the door open to more cuts and an expanded balance sheet—all without committing to anything.
Looking forward, another 25bp cut in 2019 is fully priced in for now, with October vs. December looking like a toss-up.
Unexpected surging repo rates captured investors’ attention last week, as a sharp spike in funding costs against an ongoing backdrop of reserve scarcity in the banking system prompted fears about macro implications. While last week’s developments do warrant an awareness of potential risks down the road, our sense, after speaking to hedge funds and other market participants, that this event was ultimately short-term and technical in nature.
On the supply disruption, crude rallied +15% last Monday in response to Saudi’s supply disruption that suspended 5.7mm bpd of its production (vs. recent run rate of ~9.8mm bpd). Expectations for a sustained impact, however, faded, with both Brent and WTI contracts ending last week nearly 7% below the Monday highs. It’s also notable that the Energy sector rally was likely unhelpful for active managers. According to some of the surveys we follow, net exposure to the sector is at 2.4% (1st %-tile since ‘10) and energy related ETF's have seen ~$5.5Bn of outflows YTD.
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. At the same time, though, we feel like the data has generally been pretty good as of late. Industrial production, Retail sales, Housing starts, and Jobless claims have seemed fine. Perhaps, it’s time to refocus on single-name stocks / ramp for 3Q earnings season…
World equity markets are close to their highs (even after the resilience exhibited in the month of July, as the S&P 500 touched an all time high of 3027 on July 26th, 2019 versus the closing of September 23rd, 2019 of 2992, just 1% off the highs), fears of slowing global growth are alive as well, rates are setting off warning signals, and the blame game.
The week of September 9th, was defined by an unwinding of consensus trades, with Momentum hit particularly hard down 12% on the week and down 19% from its Aug 27th peak.
MTD the Russell 2000 Growth is +2.53% (and +18.7% YTD) and the Russell 2000 Value is +6.2% (and +12.45% YTD).
This rotation occurred in a risk-on macro backdrop—Cyclicals outperformed Defensives by over 8%, while the S&P 500 rose ~1%, the US 10y rose by 34 bps, the 2s10s curve steepened, and gold fell.
This Momentum unwind is starkly different from the 4Q18 unwind in terms of fundamental drivers and performance. The current rotations were driven by upside surprises in economic data and optimism over trade talks that drove short covering, while last year’s unwind was brought on by a growth scare—data deceleration, trade tensions, and CB tightening. The October 2018 shock was also more painful with funds down nearly 4% in the first few weeks of the month, versus the average Americas L/S fund only down 40bps MTD.
Looking ahead, there is likely more de-risking over the next few weeks on the back of this volatility shock. Positioning has not radically changed. Based on conversations with some of our fund managers, they do not plan to change their overall portfolio structure and view this as a technical unwind. For this to evolve into a multi-month unwind, there will need to be additional fundamental catalysts that clearly signal an improved growth environment.
Again, we do NOT believe what we are seeing is like 4Q18. If anything, this appears to be more similar to early 2014, largely due to the elevated valuations of Growth Software and the wide Growth vs. Value spread which could drop further. One saving grace here is that if the market stays positive, the pace at which we have witnessed these rotations may not continue at quite as swiftly as it has over the last week. When viewed through a short-term lens, the recent style rotation seen in equity markets and recovery in bond yields may look excessive. Set within a longer-term perspective, however, bond prices remain close to 2 standard deviations above their 12m average (our definition of ‘overbought’) and Value stocks are -1.5 standard deviation below their relative 12m average versus their Growth peers and remain very close to their all-time relative valuation low in early 2000.
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.
Taking a step back, it seems to us that there are three debates currently going on within the market.
The first —which we would consider to be largely consensus— is that with the global growth dynamic looking anemic at best, and dovish central banks doing what they can to support both the global economy and the markets, investors continue to deploy a barbell-like approach within their respective strategies.
On one side they own expensive, high growth names, while on the other they balance this with names from more defensive characteristics — all the while avoiding cyclicals. This has worked so far YTD (albeit not over this past weeks), 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 house view of several of the banks and asset management houses we follow (ie Morgan Stanley, Pictet, JPM), where the global strategists remain underweight equities. These see a scope for a cyclical bear market given continued risks to earnings, capex, consumer confidence, and economic growth. In their case, they see the high growth names on the barbell (i.e. high growth SaaS, semis, tech hardware, etc) underperforming significantly, relative to the more defensive cohorts of the market (i.e. Consumer Staples & Utilities).
The third debate is perhaps the most interesting. This is the “what if we are all wrong about slowing growth after all” debate. Thus the risk-on, reflationary trade is the correct positioning to have. In this case ‘playing for the unwind’ of the consensus ‘flight to quality’ appears to be the most convex trade in the market today… a rather timely call given the rotations we have witnessed recently.
To this point, the US consumer has remained strong and a surge in mortgage refinancing this year could potentially boost spending. Also, both the Empire and Philly Manufacturing surveys recently surprised to the upside, despite surveying periods that covered the latest trade re-escalation. And US retail sales today posted a solid number, lifting estimates for 3Q consumption and GDP.
As of the close of September 21nd the Eurostoxx is +3.6% MTD and +18% YTD, and the MSCI Europe is +3.6% and +16% YTD.
On the central bank topic specifically, this year alone, Brazil, Russia, India, US, and Mexico (to name a few) have already cut, and the week of September 9th, we had the ECB. The result was mixed — both the headline rate cut (-10bps) and monthly purchases (€20bn) were smaller than expected, but the forward guidance was much more dovish.
Some strategists view that central bank easing is not always positive for markets as the cycle turns—namely for confidence. They think it is particularly negative in an environment where it is a reaction to weaker fundamentals and trade policy shocks.
Looking to Europe, it seems sentiment towards the region has worsened and it is now even more unloved than it was before—who thought that was possible ? European net exposure (measured by European equity long/short hedge fund exposure) is at its lowest point in 7 years, having dropped 13% points in 6 weeks from 32% to 19%. The current level is now lower than Q4’18 and the lowest level since July 2012. None of this is truly surprising given the complexity of and uncertainty around the geopolitics in the region. There are a whole host of concerns at the macro level that sometimes looking beyond them to the single stock level becomes difficult. But for those who have a view there are ways to express that view through the FX markets, indices, and single stocks.
Asia and Emerging Markets
As of the close of September 23rd the Topix +6.9% MTD and +8.2% YTD, the MSCI Asia ex-Japan is +3.5% MTD and +5.6% YTD, and the MSCI Emerging Mkts. is +3.75% MTD and +5.75% 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 -15% and -10% respectively since the end of 2017.
In Japan broadly, we have continued to see a strong rally (TOPIX up 6.9% in September) due to the recent ‘value bid’ and USDJPY hovering 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.
Asia recently has been all about India, where the government shocked the market by reducing the corporate tax rate from 30% to 22%. It also created a special 17% rate for companies starting new manufacturing facilities before March 2023. Given poor investor sentiment and a lack of “animal spirits” among corporates, this was a huge positive surprise.
Currencies and Commodities
In currencies - The USD strengthened slightly around 1.099 against the EUR. Even with the tariff turmoil the currency markets have remained extremely stable.
In commodities - Markets strongly reacted 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. The initial reaction of both Brent and WTI was to rally by around 14%. However with abundant oil supply elsewhere and news that the facilities are less damaged, oil prices have fallen, and both WTI and Brent are +6% and +6.9% MTD in September (they do remain +28.6% and +20% YTD, respectively). Other markets like Gold are unchanged in September and +18.5% 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%, current 2 year rates are at 1.68%, 5 year rates at 1.4% and 10 year at 1.71% and 30 year at 2.15% (you might remember that in the last IC in August, 2 year rates were at 1.53% and 10 year rates at 1.53%).
In European Fixed income – after the ECB decision earlier in the month, the yield on Germany’s benchmark 2-year bond is -0.74% and the 10-year, is now -0.57%, 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 now. 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 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 second half 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.