European Markets Were Up..But It Was Not a Risk-On Rally
Europe was up 1% in October and back to the year’s highs, but that only tells part of the story. It was not a risk on move. There was another growth scare, a sharp factor rotation, and Year to Date (YTD) European outflows (pre-October) had been their largest since the global financial crisis. Heavily shorted stocks outperformed by 5% on the month in aggregate and momentum was hit hard, driven by the move in US rates. European cyclicals vs defensives at one point had the biggest monthly move this decade. UK domestic stocks vs. exporters had their biggest rally in history. While there were lots of extremes, at an index level European realized volatility (10-day) remained at multi-year lows. The situation in Hong Kong deteriorated and, 22 weeks into the protests, the economy fell into recession for the first time in 10 years.
Expectations were low into Q3 earnings season for industrials and Autos due to a ream of profits warnings from carmakers earlier this year and some depressed industrial production data - yet Industrials had a solid quarter and Autos rebounded. Some heavyweight EU defensives had weak figures and were punished accordingly - ABI, Danone and Unilever in particular. Positioning drove returns, with investors looking to buy any YTD underperformers. As a result, the DAX was the best second-best performing market in Europe in October (+4%). Positive noise around a US-China trade deal also had an effect.
Almost every day brought a profit warning from a UK industrial or consumer cyclical. Recent weak consumer spending and confidence has not been down to lack of spending power, it has been down to worries about the future and the huge political noise around Brexit. Whilst clearly some money has come back in to UK names on the removal of no-deal risk, market sentiment remains cautious. Sterling was logically the best performer this month (+4%) after the EU and the UK agreed on a Brexit deal, with ‘cable’ breaking 1.30 after UK Prime Minister Boris Johnson’s deal was supported by parliament.
Politics, Growth & Monetary Policy
Three factors drive markets in October: Politics, Growth & Monetary Policy. As the saying goes, the FX market tends to be a much more accurate (and earlier) indicator of sentiment than equities and this month was no exception. The Dollar fell -2% as sentiment improved on the trade and the Brexit front, economic data softened further, and the Federal Reserve (Fed) cut rates for the third time this year. With the Fed “put” firmly in place, the backdrop for US equities continues to be attractive. Although the Fed appears to be signaling a pause in the current rate cycle, Chairman Jerome Powell’s message was clear. A "material" deterioration in the outlook may lead to a "material" reduction in rates. We have reached all-time highs on the SPX index with expectations for further gains driven by a Goldilocks type of environment. We have seen better than expected quarterly results (with over half of the SPX having reported, nearly three quarters of the results have come in ahead of their respective consensus forecasts. This compares to the historical average of 68% since 2004).
Buybacks Back In Play
Expect corporate buybacks to be in motion in the coming weeks with the majority of the S&P 500 emerging from blackout with most of heavyweights having now reported (Apple, Google, Mastercard etc). Seasonality could be another factor in play. Looking back 30 years, Q4 is typically the best performing quarter for US equities. In addition, it is highly unlikely policy makers would allow another large down draft, like the one we experienced at the end of last year. Despite reaching record levels on the index, exuberance in the Initial Public Offering (IPO) market has not followed. October saw several IPO’s withdrawn across the regions and deals that did do well were priced at the low end or below the range. BofAML point out that in October 6 out of the 17 IPOs have priced below the range. With Thanksgiving set to limit the launch window into year-end, it is likely we see a max of 5 $1bn+ mkt cap companies coming to market in that time frame.
- Over the month, markets generally rose in October, with equities outperforming bonds, and Japanese and emerging market equities leading the gainers.
- UK equities underperformed, as the approval-in-principal of Boris Johnson’s EU deal boosted sterling, acting as a headwind to large-cap UK equities which tend to generate majority of their revenues abroad.
- October was a strong month for Quality stocks in the MSCI AC World Index, Europe and US. In general, Cyclicals outperformed Defensives in October, although regionally it was quite a mixed month.
- Health care was among the strongest performers in most regions, while consumer staples were generally weak, due to a lacklustre earnings season. Energy stocks underperformed as oil prices remained under pressure as continuing concerns over US-China trade talks and uncertainty over the broader global economic growth concerns dampened the demand outlook.
- Earnings Per Share (EPS) growth forecasts were cut again in all regions and most sectors in October, and 2020 forecasts are also starting to see some downgrades.
Spotlight - Reasons to be positive
- While there is much for the market to work about, tactically it is tough to be overly negative.
- In the US, the upcoming election significantly reduces the chances of a recession. There is a lot that Trump can do to ‘juice’ the economy (constant pressuring of the Federal Reserve (Fed), a minor trade war resolution, payroll tax cuts, fiscal stimulus for infrastructure build, etc.). Employment in the US remains at pretty high levels and whilst company indicators would suggest that we are already in the midst of an industrial recession, given the strength in the US consumer, it is tough to imagine we are in the midst of a broad-based US recession as some commentators have suggested.
- While there is no hard data to back this yet, when we look at industrial orders (machine tool order series), companies have become so defensive, aggressively running down their inventories, that even the smallest hint of positive sentiment could trigger a significant inventory re-stock. This tends to be a powerful driver of sales and margins as we saw with Apple orders and supply chain pressure when iPhone demand surpassed expectations. Cyclical Japan which can be thought of as the industrial heartbeat of the global economy seems to have a pulse since September (the same cannot still be said for Germany yet).
- The Fed and the European Central Bank (ECB) have decisively shifted from Quantitative tightening to Quantitative easing. Broad liquidity and money supply growth has rebounded in most parts of the world and especially in China it has stabilized. This has clearly had a positive impact on markets this year.
- Earnings Watch: While 2021 estimates seem too high we seem to have passed the worst of the earnings downgrade cycle for FY2019/2020 and as the recent earnings season has shown us, cyclical stocks are no longer going down on bad news and some are actually going up on bad news (if stocks don’t behave the way consensus expects them to behave on bad news - take notice). As one of our US portfolio managers commented on Caterpillar earnings (ticker: CAT) - CAT did not behave like a DOG post results!
- US equities rose in October, supported by positive developments in US-China trade negotiations, and a further reduction in interest rates by the US Federal Reserve (Fed). Most sectors generated positive returns with health care, information technology (IT) and communication services among the leading gainers.
- There were indications during the month that US and Chinese governments were close to finalising some portions of a “phase one” trade agreement, leading to improved investor sentiment. On the policy front, the US Fed issued an interest rate cut of 25 basis points at the end of its two-day Federal Open Market Committee (FOMC) meeting as widely expected. This was amid muted inflation pressures and concerns about the economic outlook. Interest rates now range between 1.50-1.75%.
- Macroeconomic indicators were mixed in October. US Gross Domestic Product (GDP) came in better-than-expected at 1.9% in the third quarter following an expansion of 2.0% in the second quarter. The beat was mainly due to continued consumer spending as well as government expenditure. The decline from the previous quarter was because of falling business investment.
Spotlight - Earnings In Focus
- We expect earnings to be a key driver of market performance next year. We are clearly late in the cycle and some indicators, such as manufacturing survey data, look weak. However, this does not carry the same weight it used to. President Trump has recently signalled his desire for more fiscal stimulus, as he enters an election year, to follow the corporate tax cuts that proved such a boost to US company profits in 2018.
- Holding up the economy in the face of industrial weakness is the strength of consumers, especially in the US, but also globally. The result of this unprecedented level of divergence between consumer and industrial sectors is a greater divide between companies with strong balance sheets and those with weaker balance sheets, which tend to be industrials. We believe consumer strength is enough to sustain the US economy because the consumer has never been so big, both in absolute and relative terms. Fiscal stimulus next year should further support the consumer, in addition to continued easy monetary policy.
- The recent earnings season showed mixed trends within the industrials sector. Strong numbers have been rewarded with strong share price performance, but weak results have also been greeted with price rises. For example, Knight-Swift Transportation shares held up, despite a massive profit warning. Markets seem to be thinking the worst is behind us. In the consumer staples we saw quite different trends - in-line earnings saw stock prices fall while misses have been punished.
- The biggest surprise on the US bank earnings was the revenue growth, which was not expected given the yield curve behaviour earlier in the third quarter. Overall trends pointed to a small revenue growth, but lower than expected loan growth, while deposits have grown despite being in negative territory in the past few quarters. Net interest income was flattish, while efficiency ratios has also not improved much. Mortgages were also very strong, but off a depressed base.
- Stock Watch: Supermarket chain Kroger's stock fell after rival Amazon.com ramped up the competitive environment by removing the additional cost for Amazon Fresh, which used to be $15.99 per month, so it will now be available for free for all Amazon Prime members. The news negatively impacted the share prices of grocery companies.
- European equities delivered positive returns in October amid improving geo-political conditions and a better than expected third quarter results season (although helped by lowered consensus expectations). Cyclicals outperformed defensives with consumer discretionary and industrials among the top performers. From a style perspective, value stocks outperformed growth stocks while large-cap companies underperformed small and mid-caps.
- The eurozone economy continued to grow at a modest pace in the third quarter, with GDP growth of 0.2% in the region. However, the economy remains fragile given the region’s dependence on international trade with China. The flash eurozone Purchasing Managers Index (PMI) for October remained at 45.7 for manufacturing and rose slightly for services to 51.2, to give a slightly expansionary composite reading of 50.2. Inflation in the region fell to 0.7%. Meanwhile, the unemployment rate remained steady at 7.5% in September, the lowest level since May 2008.
- October saw Mario Draghi’s final meeting as ECB president. Incoming president Christine Lagarde inherits limited room to further stimulate the economy through monetary policy.
Spotlight - Brexit: A Sign Of Market Fragmentation
- Brexit has dominated UK politics for the last three years - and may do so for years to come, even if a departure from the EU is sealed. But the political uncertainty it has spawned is mirrored in many markets across the world - the political discord is not just a UK phenomenon. The UK's decision to leave the EU is just part of a fragmentation going on around the world as public demands for politicians to address the wealth gap and curb the growth of globalisation gather momentum. This has driven the rise of populism and protectionist measures such as tariffs and capital controls. These issues reflect weakening political support not only for a global trading system, but also for a global financial system in which capital has flowed almost seamlessly around the world.
- The UK now exports more to the rest of the world than it does to the EU, which is the destination for 46% of UK goods and services. The growth of non-EU trade marks a long-term trend that was exacerbated by the eurozone debt crisis and is expected to continue whatever the outcome of Brexit. As a result, the UK will need its trade agreements with the rest of the world to pick up the slack.
- European Earnings Season: According to Morgan Stanley Research, European Q3 earnings have so far delivered a net beat on consensus estimates. Earnings are currently down close to 5% year-on-year (the third consecutive quarter of declines), but there are signs we are approaching a trough. Over 30% of companies have beaten EPS estimates by 5% or more, while 27% have missed. This remains quite modest relative to history and comes following large cuts to consensus estimates just ahead of results. Overall, earnings revisions in Europe remain deep in negative territory, not just on 3Q earnings but also on estimates further out.
- A brief note on Environmental, Social and Corporate Governance (ESG): Our European staples analyst recently completed the roll out of her sustainability ratings on the sector. These companies are among the leaders in integrating ESG into their daily business practices and the sector is highly rated by external providers. Our focus has been on the extent that ESG is embedded in a company’s culture and its commitment improve. The majority of companies scored well, with the exceptions in the drinks and tobacco industries. As a consequence of the analysis, the analyst raised the cost of capital for tobacco names and downgraded her expectations for the sector.
- Japanese stocks advanced in October and continued to outperform other developed markets, supported by progress in US-China trade talks and expectations that corporate earnings were close to bottoming out. Overseas investors were net buyers of Japanese stocks for the first time in six months.
- In terms of style, high-beta stocks and 12-month underperformers staged a strong return reversal in October. Small caps also outperformed as risk sentiment improved. On the other hand, low beta, low dividend yield and high-priced stocks were relative laggards. At a sector level, economically-sensitive segments, led by metal products and marine transportation, gained on expectations of a pickup in the global economy.
- Monthly economic data indicated that activity in September was stronger than expected. Industrial production improved and front-loaded demand boosted consumption ahead of October’s sales tax hike. Sales of household durables and cosmetics were particularly strong.
Spotlight - Central Bank Policy
- The Bank of Japan (BoJ) kept its monetary policy unchanged, but amended its forward guidance to recognise that short- and long-term rates may need to be lowered to counter potential downside risks to economic activity and prices. Under the new guidance the central bank 'expects short- and long-term interest rates to remain at their present or lower levels as long as it is necessary'. The BoJ maintained its short-term interest rate target at -0.1% and continued its pledge to guide 10-year Japanese government bond (JGB) yields to around zero per cent, by a 7-2 vote.
- Japan’s economy faces both internal and external challenges. This month’s hike to the national sales tax threatens to drag down consumer spending at home, while global growth faces hurdles and US-China trade tensions persist. Interest rates are already in negative territory, so options for further monetary easing are limited. Deeper cuts into negative territory would have taken a steep toll on Japan’s financial institutions, particularly regional banks, which are already feeling the pinch of the country’s super-low interest rate environment.
- Future BoJ action is subject to domestic and global macroeconomic trends as well as other key central banks’ actions, and also to where the yen is trading. For now, with markets still basking in the rising optimism over US-China trade disputes and fewer apparent risks of a US recession risks, the central bank is likely to hold policy steady at its next monetary policy meeting in December.
- However, improving global macro-economic conditions would not solve the BoJ’s most crucial problem: a lack of effective easing tools to boost inflation and growth without further hurting the domestic financial system already groaning from the impact of negative rates. While the central bank signalled its readiness to take additional easing measures if needed, if it continues to slash its inflation forecasts without any real actions, the central bank might face another problem - how to maintain market confidence in its future actions.
- Emerging market equities performed strongly in October following a prolonged period of underperformance relative to developed market equities. Despite this, industry wide EM fund outflows remained high, with $3.5 billion exiting the asset class in October. Chinese stocks were buoyed by a more positive backdrop as the US announced the suspension of tariff hikes on Chinese goods and hopes of a “mini deal” between the US and China lifted sentiment. As trade fears abated, the positive effects were felt more broadly across the emerging world; Taiwanese stocks traded higher, further supported by an improving outlook for the technology sector in 2020.
- Continuing the trend of central bank easing which has been evident across the emerging world, South Korea’s key index gained after the Bank of Korea cut its policy rate to support a slowing economy and address mounting deflationary pressures. Elsewhere in the emerging Asia region, India reported subdued macroeconomic data, however the Indian market delivered positive returns as earnings exceeded market expectations.
- Latin American securities were positive during the month. The region’s largest market, Brazil, gained after the Senate approved a pension reform bill to stabilise public finances and restore business confidence. Whilst this trend of positive performance was also evident in Mexico as the equity market advanced, the fortunes of Argentina were less positive. The Argentinian market declined as investors awaited signals on President-elect Alberto Fernandez’s future policy direction. Equities in the emerging Europe, Middle East and Africa (EMEA) region gained. Oil prices rallied as news flow indicated that the world’s major oil producers may cut production, lending support to the Russian Market. However, the Saudi Market disappointed as high negative earnings revisions dragged the market lower.
Spotlight - Argentina Elections
- As was widely expected after the landslide primary election victory in August, Alberto Fernandez won in the first round with around 48% of votes. Fernandez will take power on the 10th December. The recent experiences of Ecuador and Chile may serve as examples that orthodox economic policy can trigger social unrest. Therefore, it is difficult to see Fernandez pursuing harsh fiscal austerity measures in the short term. The central bank tightened capital controls which were already in place after the primary election; purchases of US dollars for Argentines are now restricted to just $200 per month. The big open questions for equity- and bondholders remains the new administration’s relationship with the International Monetary Fund (IMF) and any associated restructuring of debt. It is still unclear what the new government’s priorities will be and the policy framework that will be established. A debt restructuring is expected but with little clarity on whether it will be an extension of debt maturities or an aggressive cut.
- EM Outlook: As we look ahead, Emerging Markets equities are set to face considerable uncertainty as 2019 ends, both economically and geopolitically. Many emerging market central banks have sought to lend support to the economy, with the easing of monetary policy. However, the US Dollar remains a conundrum. In face of heightened volatility, it has been perceived as a safe haven, which represents a potential headwind for the asset class. Nevertheless, as the US continues to exhibit a twin deficit which should be more conducive to a weaker dollar over the long-term.
- Earnings Watch: According to J.P. Morgan estimates, MSCI EM 2019/20 EPS have been revised up marginally by 0.5%/0.7% in October. Among regions, Latin America saw negative earnings revisions, EMEA was flat while EM Asia saw ~1% upward revision to its 2019 EPS estimate. Argentina, Poland, Hungary and Czech saw the biggest upward revisions to 2019 EPS. On the other hand, Turkey, Qatar, Saudi and South Africa saw the highest negative revisions over the month.
Asia Pac ex Japan