Posted by on August 14, 2017 4:59 pm
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Categories: Bond Central Banks China CPI Credit Conditions Economy Equity Markets Eurozone fixed SocGen Volatility

While most banks have in recent weeks expressed concerns about the recent, near record high levels in the S&P – which is now 67 points above Goldman’s year end price target of 2,400 – few have been willing to go out on a limb and announce they are short the market, and that the bull market is now over (unlike Gartman who on Friday staked his reputation that the “Bull market has come to an end” only to unleash another rally in the S&P in the next two days).

Overnight, JPM’s Misla Matejka has done just that, and in his latest equity strategy note writes that JPM “continues to see the risk-reward for equities as unattractive” for 4 main reasons: i) complacency seen in VIX and in HY spreads could unwind further, ii) EPS momentum is deteriorating, iii) valuations are “outright expensive”, and iv) liquidity will be turning.

If the JPM strategist had left it at that, it would have been notable as it would be one of the very few, unhedged bearish recos on Wall Street. He did not, however, and said that after the early periof of turbulence, markets will continue rising, effectively nullifying his warning because what’s the point of selling just to have to buy again a few weeks or months down the line, or as Matejka put it the “medium-term fundamental view remains that equities are in an upcycle and that the potential consolidation should be used as another good entry point.”

Hedging aside, here are the details of Matejka’s short-term bearish call, who writes that “we have been very bullish on equities in 1H, but think they will be consolidating during the second half of the year. Equities performed strongly in 1H and the key positive catalysts moved behind us. Now that SXXP is down 4% since May, where to from here? We believe a continued weakening in USD will keep helping EM & commodities (OW) and any rise in Bund yields will help Eurozone Banks (OW), but we think broader equity markets are likely to continue consolidating.”

Looking at the big picture, JPM sees the following “headwinds” as immediate red flags:

  • 1) The change in liquidity provision by the main central banks is likely to have an impact on equities, given very elevated P/E multiples currently. In 2H ’13, Fed tapering was ultimately positive for equities, after an initial correction, but then the starting P/E for MXWO was 30% cheaper than current. Also, CPI, PMIs and EPS were all up then, but that might not be the case this time around. Will central banks make a “policy mistake” by tightening liquidity into potential growth and inflation weakening? Within this, we think US bond yields remain stuck in a range, but the potential for Eurozone yields to move up is greater.

  • 2) Earnings delivery likely to weaken in 2H, post a strong Q1 and still adequate Q2. We were very bullish regarding the upturn in earnings, but the hurdle rate is much steeper in 2H and the base effects are turning less positive. The potentially weaker activity and pricing backdrop into year-end could be the headwind. Global PPI, which is typically strongly correlated to global EPS momentum, is likely to decelerate in 2H. After spending months in positive territory, we note SXXP EPS revisions are outright negative now, lead lower by Cyclicals. Stocks’ reaction to Q2 misses, and to the beats, was poorer than typical.

  • 3) Soft patch in global activity ahead? US growth momentum is mixed, with a rollover in manufacturing, credit, housing and car sales. US CESI is negative – the gap between CESI and SPX remains uncomfortably high. China new project starts are soft. The last time this happened, in summer ‘15, a phase of significant de-risking followed. A big stimulus package stabilised the activity then, but this time around, a new support programme might not be forthcoming. Shibor rate is up 200bp ytd. Eurozone has been very strong so far, but even that region could see some softness ahead. We note Eurozone PMIs are sequentially lower for two months in a row.

  • 4) Equity multiples are in outright expensive territory. There is some complacency in risk pricing, with HY spreads near record low, and VIX as well. Aug-Sep seasonals were typically weak

Enough for JPM’s bearish near-terms: now here is the longer-term bullish perspective: as part of the hedge, the JPM strategist asks if “the potential increase in volatility during the 2H something that might become more sinister than just the typical profit-taking given poorer seasonals, a valuation headwind from bond yields repricing, and a likely soft patch in global earnings and activity momentum?” And answers “We don’t think so.” Here’s why:

  1. Earnings base remains depressed in EM and in Eurozone. There is significant medium-term upside potential from here in both regions.
  2. Credit conditions are supportive, real rates are low and yield curves are generally steep.
  3. Equities are still under-owned, where the only buyers over the past 10 years have been the corporates, through buybacks. There are some signs that this is starting to change.
  4. Even though in absolute terms equities appear pricey, the relative value proposition between equities and fixed income still holds.
  5. USD behaviour might not add to the risk-off concerns. Typically, as one enters a de-risking phase, USD has tended to rally. This, in turn, has become a problem for EM, as the EM central banks need to hike interest rates in order to protect their currencies, which ultimately hurts EM growth. Also, a rallying USD is a headwind for commodity prices. We do not see USD strengthening this time around.

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The cliff notes version of the above, of course, is “hedging one’s bets”: if stocks drop, JPM has 4 reasons why that should have happened. If they don’t, JPM has 5 reasons why they should continue higher. Perhaps the most important take home from all of the above is the following statement from JPM: “the only buyers over the past 10 years have been the corporates, through buybacks.” This is a concern, because as we showed earlier using a SocGen chart, the amount of corporate buybacks has declined by 20% Y/Y, the biggest drop since the financial crisis…

… leaving open the question “who will step in to buy”?

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