Reduced uncertainties return investor optimism, but no clear skies there yet

Darius Svidleras
Investment Portfolio Manager
 

• Supported by reduced political risks and increase in monetary stimulus, global equities updated new 2019 highs
• Risk of global economic recession still remains elevated, thus ongoing rally might not be sustainable despite investor optimism
• Forward guidance on earnings growth remains strong, but may be subject to reevaluation should the economic slowdown continue

Excluding the selloff in the first two trading days of October, when global equities dropped by almost 3%, the rest of the month was rather calm, allowing stocks to steadily rise in price, updating their 2019 highs with the onset of November, and in case of US indices even making new all-time high. Such positive dynamics was achieved due to mitigation of several major risks, which we also discussed in previous report.

First of all, trade negotiations resulted in successful outcome between USA and China. After Chinese vice premier Liu visited Trump in Washington, both countries agreed to reach preliminary deal. Written agreement is still to be developed and signed, but USA as a measure of good intention has already cancelled planned increase of tariffs on Chinese goods in October. Moreover, throughout the month representatives of both countries were reassuring investors that further progress in trade discussions is being made and written deal is almost finalized and is certain. 

Another reason for modest optimism was linked to Brexit situation in Europe. Long story short, UK prime minister and EU leaders were able to agree to a deal, but UK parliament decided that more time is needed for them to fully understand the details of the new proposed bill to accept it, and thus Brexit deadline has to be moved once again. EU agreed to provide extension and move the new deadline to 31^st of January 2020. Overall, similar to USA/China discussions, European leaders tried not to escalate situation around Brexit, sending message to the financial markets that the process of UK separation from EU would be tried to be made as smooth as possible.

Also in October there was another round of major central bank meetings. In Eurozone there was no major change to existing monetary policy, as all attention was linked to the departure of Mario Draghi after his 8 year tenure as the ECB president. At the same time FED continued to reduce interest rate. With the third consequent cut to 1.75%, FED once again tried to ease financial conditions to prevent the US economy from slowing down. However, FED chairman Jerome Powell also indicated, that additional cuts are unlikely to happen in the foreseeable future, unless economic conditions would significantly deteriorate from current levels. In that regard, FED is likely referencing to data on employment which contrary to some other macroeconomic statistics still remains strong in USA. Specifically, unemployment rate in September was 3.5%, lowest reading in the last 50 years.

US unemployment rate

Source: Bloomberg

Indeed, historically start of two previous major bear markets and economic recessions coincided with first negative monthly change in number of employed people¹ late in the US economic cycle.  Since September 2010, US economy was capable to create additional jobs for every single month, and until this number would continue to remain positive, it is reasonable to expect that stock market would still have powder to rise higher, even if other macroeconomic data is showing some signs of weakness.

US monthly employment change vs S&P-500

Source: Bloomberg

Continuing discussion on USA, it is important also to mention relatively decent corporate financial reports for third quarter 2019. Based on already published data from 356 companies in S&P-500, their total corporate earnings declined  by only 0.8%, while total revenue increased by 3.7% compared to last year². While these numbers are far from being strong, the result is still quite solid given weakness in the global economy and trade uncertainty witnessed throughout this year. But what is more encouraging, analysts now believe that earnings growth may again become slightly positive next quarter, and as high as +10% in 2020, after some positive forecasts were provided by companies’ management.

Refinitiv earnings 2019-2020 projections

F – forecast
Source: Refinitiv

So there were certainly reasons for rising investor optimism by the start of November, with large number of financial pundits reasoning that equity prices should increase even higher in the upcoming months. While such statements may turn out to be true, we want to stress out that any sustainable increase in prices needs to be confirmed by improvement in economic indicators as well. And unfortunately we still see no such confirmation, as OECD leading indicators are still trending down. Moreover, if previously slowdown in economic activity was mostly linked to manufacturing impacted by weakness in global trade, currently we also see some disturbing trends in economic activity linked to services, which usually remain more resistant to external factors.

OECD total composite leading indicators vs global equities

Source: Bloomberg

Global manufacturing and services PMI vs MSCI ACWI

Source: Bloomberg

And even if we try to dig a little bit deeper in what appears to be truly positive data, such as aforementioned employment numbers in USA, we will find “red flags” there as well. Employment change is still positive, but growth is constantly getting weaker throughout the year, and in October it repeated the worst result since 2011. Or let us take Q3 reports, while US earnings were relatively fine, in Europe decline constituted 8.4% based on recent data, and this is concerning.

Growth in non-farm employment change (y-o-y)

Source: Bloomberg

Then let us return to the topic of trade negotiations. How many times this year we heard from the Trump administration about trade discussions going well and being in final stage, only to find out later that instead of promises tariffs were increased again. As there is still no written agreement, and both USA and China made it clear that first agreement would only resolve part of their mutual issues, further escalation should not be ruled out. As ridiculously as it may sound, one threatening tweet from Trump, and financial markets might become vulnerable once again.

Therefore, despite ongoing improvements, the risk of global recession still remains relatively high, and the possibility that equity markets would significantly drop in price, as it happened last year, is also not out of question. Nevertheless, there are several factors that point to a decent potential for stocks in the longer term. First, investor sentiment is far from extreme optimism and exuberance which is common for the market top. According to the American Association of Individual Investors 66% of investors are currently either neutral or bearish which is higher than historical average of 62%. Moreover, a significant decline in interest rates made equities more attractive relative to bonds, as stocks are still offering fairly strong earnings yield. As a result, possible volatility in the near term may provide good opportunities for the longer term investments.