Posted by on March 20, 2017 1:23 pm
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Categories: Bear Market Bond Business Corporate bond Corporate Leverage Credit Suisse DJ Euro Stoxx 50 Earnings yield Economy Euro Stoxx 50 and 20 Finance Financial ratios FTSE 100 Futures contract Insider Selling Investment banks money Nikkei Nikkei 225 Private Equity Recession Repurchase agreement S&P S&P 500 SPY UBS unemployment US Federal Reserve Volatility Wall of Worry

Following bearish reports from Goldman (which tactically downgraded stocks to Neutral for the next three months just hours before the Fed rate hike), RBC and JPM’s head quant Marko Kolanovic over the past week, overnight Credit Suisse decided to take the other side of the trade and hiked its year end forecasts for the S&P500, and pretty much every other risk asset, noting that it is happy to “climb the wall of worry”, and prefers equities to bonds. The reason for the Swiss bank’s optimism, as strategist Andrew Garthwaite explains, is that “following the reaching of our mid-year S&P 500 target, we raise both our mid-year and year-end S&P targets to 2,400 and 2,500, respectively (from 2,350 and 2,300).” He adds that “our clear-cut view is that investors should be overweight equities versus bonds and credit. We now see less chance of a second-half correction in equities and thus raise our mid-year and year-end targets to 2,400 and 2,500, from 2,350 and 2,300, respectively. We stick to our mid-year targets of 3,500 on Euro Stoxx 50 and 20,500 on Nikkei 225.”

In terms of near-terms moves, CS – unlike Goldman – sees “a clear-cut risk that we get an overshoot to the upside in equities that then reverses later on; more realistically, this reversal is likely to be a very late-2017 or 2018 event.”

Some more details behind the bank’s revised targets:

“We leave our mid-year targets on the Euro Stoxx 50 and the Nikkei 225 in place at 3,500 and 20,500, respectively, but on the back of the change to our S&P 500 target, we also increase our year-end targets for the Euro Stoxx 50, the FTSE 100 and Nikkei 225 up to 3,700, 7,500 and 21,000, respectively (from 3,450, 7,000 and 19,800). We also revise our FTSE 100 mid-year target to 7,400 from 7,100.”

Where does this optimism come from:

The big-picture positives: (i) US wage growth has been more muted than expected, making us believe the unemployment rate consistent with full employment is probably 4.2%, not 4.8%. This is critical because cycles peak when unemployment is 50-100bps below NAIRU; (ii) for the first time in 30 years the five-year risk-adjusted return of equities is better than that for bonds and realised equity volatility is now below that of bonds; this should encourage a bond for equity switch yet equity inflows are still below 2013 peak levels; (iii) earnings revisions remain positive (we raise our US EPS growth forecast to 8.7% from 6%); (iv) we think inflation expectations will rise closer to 3% (2.2% currently) and equities do not de-rate until inflation rises above 3%; (v) above all, equities remain the least expensive major asset class: the ERP is 5.4% vs warranted of 4.1%; and (vi) excess liquidity is consistent with re-rating.

The tactical issues that don’t worry us: (i) lead indicators are peaking (but c71% of the time on a 3-month view the S&P can rise); (ii) some sentiment indicators are becoming excessive (e.g. bull-bear/insider selling, but our aggregate measure isn’t); and (iii) the market has typically risen c5% in the 6 months after the third Fed rate hike.

Unlike other banks, CS does not an imminent market peak:

We see few of the catalysts for a major market peak: Prior to most market peaks (c.90% of the time), credit spreads widen, for an average of 7 months (they have widened marginally in the US, but not in Europe). Otherwise, the catalysts have been one of: very clear overvaluation (average ERP at peak of 2.5%); over-investment; equities peak 4 months ahead of a recession; negative earnings revisions; high retail inflows; talk of a ‘new paradigm’; and a sharp narrowing of breadth.

But before CS clients rush to buy up another several billion in SPY ETFs, Garthwaite makes the following cutious notes:

Two events that could make us turn negative: (i) if the unemployment rate falls 50-100bps below NAIRU and wage growth rises above 3%. This increasingly looks like a 2018 event; and (ii) if the 10-year UST yield rises to 3.0-3.5%. We think we are in the late stages of the bull market, so ultimately most of the rise in the next year would reverse into the next bear market.

Credit Suisse also notes the following tactical indicators we do worry about and that require close monitoring:

1. Non-financial cyclicals have started to underperform defensives, even as the bond yield has:

The ratio of US cyclicals to defensives has started to roll over from extended levels, even as bond yields have risen. Looking at all the significant cyclical-to-defensive peaks since 2004, it is notable that a peak in cyclicals and defensives has 83% of the time led to a local peak in the S&P within a month. This time, since the peak in cyclicals a month ago, the S&P 500 is up 3%. For a list of all recent peaks in cyclical and  defensives and the following reaction in the S&P, please see Appendix 2.

While this is slightly worrying, we would highlight that we still believe that bond yields will rise further (as discussed at the end of this report). We think this should allow banks to outperform, and potentially take over market leadership from non-financial cyclicals (banks constitute 11.9% and 6.5% of European and US market cap, respectively). Banks have also – at least in Europe – lagged the performance of non-financial cyclicals and been able to outperform in the past month while non-financial cyclicals have been underperforming.

2. Corporate net buying is slowing down

From a fund flow perspective and an earnings perspective, corporate buying has been a very substantial support for equities; corporates have been the biggest buyers since 2012 and, according to data from Credit Suisse HOLT®, buybacks have accounted for a third of EPS growth in the US.

Buyback activity appears to be slowing. The 13-week moving average is close to a sevenyear low, at the same time as buyback as a style is once again underperforming. This is also coming at a time when corporate leverage is on some measures back to previous peaks.

This doesn’t worry us too much because: First, as stressed later on, we find that even after capital spending, buybacks and dividends, the US market is still cash flow positive and the earnings yield of the S&P is still around 90bps above the BAA corporate bond yield. Second, while leverage has picked up, there are still pockets of firepower for the corporate sector. For example, according to data from Preqin, there is still about $1.4trn of private equity dry powder and some $800bn of cash (pre tax) could be repatriated into the US following corporate tax reform.

3. High speculative positions in oil, and oil being correlated to reflation

The oil price has recently experienced a sharp correction lower, and this comes at a time when speculators are very long, as we can see below. When speculators are long and speculative positions fall – which we would expect to be the case given the nearbackwardation in the 2-year section of the futures curve – the oil price tends to fall too. Historically, a decline in the oil price has been a negative for equities, and in general the reflation trade. However, we note the relationship between the price of oil and the stock market is not stable and the correlation, which was strongly positive throughout 2016, has recently started to fall.

For now, however, according to CS these are the key “tactical issues to focus on:”

(i) corporate net buying slowing and buybacks as a style underperforming (but FCF after dividends and buybacks is still positive); (ii) speculators are very long oil while the market has been moving against them, and the oil price has had a strong correlation over the past two years with risk assets (but our house view is $62pb by year-end and the correlation between equities and oil has started to fall); and (iii) cyclicals underperforming, which leads to the S&P 500 falling c73% of the time in the next 3 months (though it has not done so in the past month).

For now, however, have no fear as Credit Suisse will promptly advise its clients when to sell.

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