Year-to-date as of the close of February 24th, 2020, the S&P 500 and the MSCI World were -0.15% and -1.18% respectively. On February 24th the S&P 500 was -3.35% and the tech heavy NASDQ was - 3.7%, the worst one day correction since 2016
- We began the new year with a continuation of the December 2019 market rally. However after strong returns in January, February has been negatively affected by the coronavirus spreading in China, and now outside of China in places like South Korea, Iran, Italy and others.
- Most markets have lost most of their gains year to date. The daily losses of February 24th, have been particularly negative (S&P 500 -3.35% and NASDQ -3.7%).
- One can now argue that coronavirus may last longer than what people initially expected, and as we will explain later in this presentation, the disruption in many supply chains and consumer sentiment, could be important. On the other hand 10 year US Treasury yields are at 1.39% compared to 1.75% in the Fed Fund rates, are highly stimulative and the yield curve is now inverted.
- Having said that, short term, global markets are still very much focused on the uncertainty around how big of an impact coronavirus will have on global growth. Three potential scenarios, can be elaborated: 1) global recovery is delayed, not derailed. In this scenario, production in China resumes quickly post February (people are expected to go back to work) and 1Q20 global growth would be affected by 15-30bps. This scenario seems less likely now. 2) migrant workers face challenges in returning to work and transport logistics could take longer to return to normal, reducing global growth in 1Q20 by 35-50ps, 3) the last scenario is that the outbreak peaks in April, production activities in China and global supply chains would remain affected for longer, and 1Q20 and 1H20 global growth would be affected by 50-75bps and 35-50bps, respectively. Obviously if the virus spreads globally and becomes pandemic, then global growth could be impacted even more.
- Earnings in 4Q 2019 have been good but not great, Brexit execution risk and implications still linger, the US political environment appears to potentially more ‘challenged’ than we think, and phase 2 hasn’t been mentioned in some time … will it even happen? Regarding the phase 1 trade deal, will China be able to comply in importing the billions promised with the economy virtually “closed”?
- In the US, the breadth of the equity is the lowest since 2005, with only 38% of S&P 500 constituents outperforming the index in the past few months, and top five names now 18% of SPX market cap.
- As mentioned in earlier occasions the markets are still expecting a recovery to take hold once the disruption fades because the fundamental story remains intact:
- the support from monetary and fiscal easing - clarity on the Fed maintaining rates low, or eventually lowering if the effect of the coronavirus in growth is perceived to be worse
- strong employment numbers for November, December and January,
- the signing of a phase one trade deal between the US and China, easing trade tensions
- policy makers in China to step up easing efforts (to the tune of a cumulative 120-160bps expansion in fiscal deficit this year) to cushion the initial impact to growth.
- Brexit looking resoundingly on the right path with the outcome of the UK elections.
- Going forward, the general backdrop into 2020 looks constructive, with an accommodative Fed, a recent uptick in global data, Brexit on the right path, and what feels like the worst behind us with US/China trade tensions. However the coronavirus effect on global growth is the new uncertainty.
- The bottom line is that being long the US, growth, defensives, the dollar, and the 10 year T-bond has not made much sense historically, but in this macro environment it does…flight to ‘safety’ and ‘quality’ continues to remain supreme.
- 4Q 2019 Earnings
- Earnings Scorecard (as of February 21st): For Q4 2019 (with 87% of the companies in the S&P 500 reporting actual results), 70% of S&P 500 companies have reported a positive EPS surprise and 66% of S&P 500 companies have reported a positive revenue surprise.
- Earnings Growth: For Q4 2019, the blended earnings growth rate for the S&P 500 is 0.9%. If 0.9% is the actual growth rate for the quarter, it will mark the first time the index has reported year-over-year growth in earnings since Q4 2018 (13.3%).
- Earnings Revisions: On December 31, the estimated earnings decline for Q4 2019 was -1.7%. Eight sectors have higher growth rates today (compared to December 31) due to positive EPS surprises.
- Earnings Guidance: For Q1 2020, 61 S&P 500 companies have issued negative EPS guidance and 28 S&P 500 companies have issued positive EPS guidance.
- Valuation: The forward 12-month P/E ratio for the S&P 500 is 18.9. This P/E ratio is above the 5-year average (16.7) and above the 10-year average (15.0).
- January employment numbers, released February 7h, came out slightly stronger than expected, with 225,000 non-farm jobs created, but the unemployment rate increased slightly to 3.6%.
- Total nonfarm payroll employment rose by 225,000 in January, and the unemployment rate was little changed at 3.6%. This compares to an average monthly gain of 175,000 for all 2019.
- Notable job gains occurred in construction, in health care, and in transportation and warehousing. Over the past 12 months, average hourly earnings have increased by 3.1 percent. Manufacturing employment changed little in January (-12,000) and has shown little movement, on over the past 12 months.
- The change in total nonfarm payroll employment for November was revised to +261,000, and the change for December was revised to +147,000. With these revisions, employment gains in November and December combined were 7,000 higher than previously reported.
- Among the unemployed, the number of reentrants to the labor force increased by 183,000 in January to 1.8 million but was little changed over the year. (Reentrants are persons who previously worked but were not in the labor force prior to beginning their job search.)
- The number of long-term unemployed (those jobless for 27 weeks or more), at 1.2 million, was unchanged in January. These individuals accounted for 19.9 percent of the unemployed
Europe and the UK
Year-to-date the Eurostoxx is up -2.6%% and the MSCI Europe -1.3%.
- In Europe and the UK, PMIs recently have continued to move up.
- However, the market perception is that European growth could be affected more than other regions by the coronavirus. More reliance on China trade and now the virus spreading in Italy, could put Europe in a more vulnerable position than the US.
- However, if production in China is at at 80-100% of normal by late March, we should see this as a temporary delay in global recovery and the coronavirus will not break the fundamental story for the global economy.
Asia and Emerging Markets
Both the Topix and the MSCI Asia ex-Japan are YTD -2.75% and -4.3% respectively.
- Investor sentiment in Asia has been hampered by the coronavirus effect. After being in “recovery” or “risk-on mode” earlier in January, these markets are now in risk off. The Hang Seng Index is -5% and the KOSPI -5.4% YTD.
- Japan's GDP shrank an annualized 6.3% in the fourth quarter of 2019, following a downwardly revised 0.5% growth in the previous period and much worse than market forecasts of a 3.7% fall. It was the sharpest contraction since the second quarter of 2014, led by falls in consumer and business spending on the back of a sales tax hike, a destructive typhoon and subdued global demand.
- In Latin America, the MSCI Latam, is negative for the year, -8.3% YTD. Many countries and their respective economies are more dependent on China growth as well as on commodity prices.
Currencies and Commodities
- In currencies - The USD has strengthened to around 1.085 against the EUR. The belief that the effects of the coronavirus can negatively affect Europe more than the US has led to a weakening Euro.
- The Swiss franc continued to strengthen against the Euro, to a multiyear high after Switzerland was added to the U.S. Treasury’s watch list of currency manipulators earlier this month, and the general risk-off environment. The current level against the € is 1.06.
- In commodities – industrial metals and in particular copper prices have reversed direction since the coronavirus worries, and are now -6.6% YTD.
- In energy - International benchmark Brent crude dropped towards $56 a barrel and U.S. West Texas Intermediate (WTI) to $51, both now -16% YTD.
- Gold, after surging +18.3% in 2019, is +10.5% YTD at $1,676 an ounce.
- In US Fixed income - The yield curve has collapsed since the last IC in January, and 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 at 1.26% (last IC at 1.55%), 5 year rates at 1.21% (last IC at 1.62%) and 10 year at 1.37% (last IC at 1.82%). Finally the 30 year bond has just touched the all-time low at 1.82%.
- In European Fixed income – the yield of Germany’s benchmark 2-year Bund is unchanged since the last IC, at -0.68% and the 10-year, is now -0.48% (last IC was at -0.21%).
- 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.
- Our economic outlook anticipates a rebound in activity sufficient to provide trend-like growth and maintain high levels of employment, but not strong enough to stoke inflation and force central banks to rethink their accommodative policy. Overall, we see a year of growth and moderation ahead: Growth in terms of the economy and earnings but moderation in terms of monetary policy, multiple expansion and asset market returns. Downside risks were fading, but the worry of the effect on global growth of the coronavirus, renewed bout of trade tension and further weakness in China are key factors to monitor in 2020.
- Equity returns in 2019 were entirely driven by valuations, but given where they started — immediately following a fourth-quarter sell-off in 2018 — valuations on global equities are now roughly back in line with their long-term average. A modest, mid-single digit rise in earnings in 2020, combined with typical dividends, would suggest upper-single digit global equity returns even without any heroic assumptions on margins or valuations. One risk is that earnings could deteriorate as a result of the coronavirus. That would really challenge generous equity valuations and risky assets, and throw the balance of monetary policy and equities into question.
- Nevertheless, 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 if we have further interest rates cuts. Were global economic data to pick up more strongly than we are forecasting, it is likely that EM equities would be a beneficiary, with other more cyclical regions, like Japan and Europe.
REGARDING FIXED INCOME:
- Bonds are likely to suffer as yields rise modestly in 2020. However this has not been the case recently. Extremely low yields, flat curves and a recovery of risk appetite could be the recipe to generate a strongly negative signal for global duration.
- Consequently, 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. Fixed income is likely to see a continued hunt for yield, with higher quality corporate credit, as well as EM hard currency sovereign debt, the potential beneficiaries within the asset class.
- In a world of contained sovereign yields and accommodative central banks we still favour equities for generating returns. This economic outlook leads us to continue to be positioned with an overall overweight in equities and an underweight in global bonds - with a short duration profile. Overall we probably prefer to add units of risk to equities rather than credit. Finally, we can maintain some USD cash, where real yields are not punitive and we are afforded a little “dry powder” in the portfolio.
Sources: Global Reflections, by Nick Savone, Morgan Stanley, February 20, 2020