Global Macro & Strategy

Macro update – risk dead ahead

19/11/2019

Key themes:

  • US Equity earnings growth – S&P 500 index constituents have almost all reported for Q3 2019, and thus far aggregate earnings growth is negative for the first time in a long time.
  • US equity markets aren’t reacting yet. Instead, they are hitting all time highs on FOMO (fear of missing out) and expectations of an earnings recovery, even though earnings have been trending down.
  • There is significant risk that this optimism is overdone. The net short position on the VIX (stock market volatility) is at a 3 year high, which indicates huge bullish complacency.
  • Forward indicators that front run leading economic indicators and the stock market suggest a higher-than-normal risk period is ahead through to mid 2020, as previous tightening catches up to the real economy.
  • Short term, a key theme is that of inflation re-accelerating and hence certain commodities such as energy have popped to the upside
  • China is still slowing, and the Chinese market reflects this reality.
  • Green shoots of stabilisation in Europe. This makes sense as it was the first to peak and rollover back in 2017, and the comps start to get easier.

Macro:

The latest high frequency economic data that has been coming through has been painting a picture of divergences, with aggregate global growth still on the slow side.

Whilst parts of Europe are showing green shoots in growth (as they start to lap some easier comps), the same can not be said for other large economies.

US retail sales growth, whilst ticking up from the previous month, was lower year-on-year at 3.1%. Industrial production hit negative growth territory at -1.13% year on year, which is a 38 month low. And the ISM Manufacturing index, whilst ticking up slightly from last month, is still in contraction territory.

In China, industrial production growth has decelerated to 4.7% YOY. That’s a major deceleration in the growth rate historically. Add to that the annual growth rate of bank loans slowing to a 15 year low of 12.4% YOY and you do not have the conditions for China to be the backstop of the world economy. One of the big problems for China is the continuing strength of the US dollar.

India has the 2nd largest population in the world, and has reported import growth slowing to -19.2% YOY, the slowest rate since April 2016.

Japan machine tool orders – one of the best indicators to have in your toolkit for the global business cycle – decelerated again to -37.4% YOY.

Equities:

Earnings season in the US is wrapping up, and as at the time of writing, 462 companies from the S&P 500 have reported, with an aggregate earnings growth rate of -1.0%. That’s a long way from the mid +20’s of Q3 2018 when it all peaked.

We are anticipating that slower growth, late cycle wage inflation (which reduces margins), along with continuing US dollar strength, will both weigh on US earnings in the immediate future.

If you look historically, this inflection to negative earnings, and indeed, to a negative outlook for future earnings, is the key catalyst for bear markets – once it gets into the psyche of the market.

Yet, here we are with the S&P 500 pushing record highs. To see if this is warranted, one of our tools is to look at how the year-on-year growth of the S&P 500 price index is tracking, based on its historical correlation to previous stimulus or tightening in the system.

Source: Refinitiv Datastream / Lonsec Research

So far, its actually all looking pretty normal, with the rise in the market in line with the overall upward trend of the blue line over the same period.

However, as can be seen from the chart, the blue line (which is a composite of factors that represent tightening or stimulus in the financial system) indicates that we are coming up to a period in front of us over the coming months where market risk is significantly higher-than-normal.

The thing that could delay this scenario (at least temporarily) is that the current data seems to suggest the US and China in the short term are both in a slowing growth / accelerating inflation setup. This “stagflationary” regime historically tends to be one where markets peak, and things like oil and commodities increase in price (both of which have been happening). They don’t tend to be overtly negative for equity markets, however once inflation peaks and falls, risk rises dramatically.

The bottom line:

The combination of all the above factors present SMSF and other self managed investors with a period time ahead where risk is elevated in assets such as domestic and global shares. Due to the emergence of a positive move higher in inflation, this may be delayed for a period of time, however the risk still remains.

Author: Graham Parkes

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