A view from the equity market
- While the sell-off in US Treasuries is more a threat to spread products than to equities in general, recent activity is suggesting some technical correction may be coming.
- Within equity markets this is being reflected in rotation from defensive to cyclical, but now is the time to be more stock specific and look carefully at margins. Cyclical growth might not drive too much inflation, but it shifts pricing power.
- Most of Asia’s returns last year actually came from earnings rather than multiple expansion, but it is nevertheless increasingly important to focus on individual company earnings.
The trends that we saw established in January appear to be continuing, the momentum stories from last year, particularly here in Asia, seem to still be running – the MSCI China index is off a little bit in the last few days, but is still higher than last time we wrote. Meanwhile the US 10 year yield also continues to rise. Last time we mentioned it had broken its long term moving average it was at 2.535%, currently it is at 2.788%. Simple chart reading suggests resistance at 3% and certainly it makes sense intuitively that large long term institutions seeking to match assets and liabilities would start to come in at those sorts of levels.
The strong start to the year for equities has led many (most) people to ask when it is all going to go wrong. Certainly the returns in Asia were spectacular for many investors last year – even if they were only playing catch up with the west and there is no doubt that the US market in particular is looking frothy. Last year the S&P 500 had its second highest risk adjusted return in more than 50 years for example and some short term risk indicators are certainly flashing amber if not red. Chart 1 shows one of the amber lights – the Bull Bear sentiment index (here I subtract bullish from bearish to get a net figure).
Chart 1: Bull Bear Index
Source: Bloomberg, AXA IM, February 2018
The chart is fairly noisy, but the annotations show that from this sort of level, while markets might not crash, they tend to move sideways at best for a while.
Elsewhere, we note that there has been a sharp increase in margin trading, while Morgan Stanley point out that January saw very large buying of futures with net holdings of S&P calls at the highest and S&P puts at the lowest since 2010. Indeed skew is now close to 10 year lows, with puts very cheap compared to calls, suggesting that probably the best contrarian short term trade/hedge for Q1 2018 would be to buy a few cheap puts on the S&P. Longer term, we would point to the benefits of diversification away from the US equity market – on a forward long term P/E measure, CitiBank suggest that non US equities are now as cheap against US equities as they have ever been, and as we never tire of pointing out, the changes in Asia mean that in addition to valuation, you also have strong balance sheets, strong earnings and growing dividend payout ratios.
Also for a US investor there is the prospect of stronger currencies and the reality that Asia never benefited from quantitative easing (QE) so will be less vulnerable to the effects of its wind-down. Indeed, this could already be going on in the bond markets. The chart shows how the sell-off in US treasuries since mid-December (here proxied by the ETF ticker TLT in black) has been accompanied by a sell off in the US dollar as represented by the trade weighted index DXY in orange. If so, stability in Treasuries may be reflected in (or even preceded by) stability in the dollar. Interesting to note how unloved the dollar is at the moment, after three or even four years when everybody began the year loving it.
Chart 2: US Treasuries and the dollar are selling off together
Source: Bloomberg, AXA IM, February 2018
As previously discussed, this may well reflect a simple switch from US bonds to emerging market (EM) bonds – certainly higher yielding EM sovereigns and their currencies have both done well year to date, but it could also reflect a switch out of US corporate bonds. Chart 3, shows the US high yield bond market as proxied by the HYG ETF, which we noted at the turn of the year was looking vulnerable on the chart and we can see that not only has it broken down below its long term moving average, but there is little obvious price support.
Chart 3: High yield bonds looking vulnerable
Source: Bloomberg, AXA IM, February 2018
Before getting too carried away, we should remember that the big sell-off in 2016 was caused by weakness across the energy space – a lot of the HYG companies were exposed to shale oil and gas and over-expansion had driven down oil prices and was seen to be threatening their cash flows. This time the sell-off is coming against a background of higher oil prices (albeit US shale production is set to pick up again) suggesting something different is going on. To my thinking this is a spread widening story. The higher Treasury yields are less a threat to equities (as is always claimed by the ‘heads we win, tails you lose’ bond analysts) and more of a threat to spread products.
This notion that anything that is good for bonds is not good for equities but that anything that is bad for bonds is even worse for equities has appeared at regular intervals over the last twenty years of the bond bull market, let alone the last near decade of quantitative easing. Such analysis is usually dressed up in explanations about discount rates and risk premia but rarely seems to actually turn out to be the case, the “sell everything” (except bonds) call from RBS in early 2016 is but one of the more recent examples. Partly it is because current equity valuations do not incorporate the artificially low levels of bond yields and thus a return to ‘normal’ should be absorbed by the high ‘risk premium’ – which in reality is simply the unexplained portion of the discount rate required to equate current prices with expected cashflows. In fact the bond bull market has smoothed over the fact that a short term bond sell-off is rarely bad for equities, but it has also resulted in a world where the switch between bonds and equities happens far less than it used to. Partly because the big pension funds and insurance companies are increasingly mature (certainly in the west) and partly thanks to aggressive macro-prudential regulations that make it almost impossible for long term asset liability managers to actually own equities thus weakening the arbitrage between bonds and equities has considerably. As a result, the valuation models are not behaving the way they are ‘supposed to’.
Certainly there will still be some rebalancing flows following strong equity and weak bond markets – the US long bond has returned -4.7% year to date giving back almost all its returns since the rally began last spring, while the S&P500 is +5.7% YTD and +20% since mid-March 2017, but far more likely in my view is a switch from higher yielding corporate bonds, which are probably not yielding enough even after the recent sell-off back into ‘risk free’ Treasuries. This is the natural consequence of an unwinding of QE – and is actually a bigger issue now for European corporate bonds – when the ‘artificial’ demand, either directly from central banks like the European Central Bank (ECB) or based on a spread over artificially cheap funding as in the US, disappears, then a return to ‘normal’ is required.
Chart 4: Corporate bond spreads – not much room
Source: Bloomberg, AXA IM, February 2018
Chart 4 shows the spread between corporate bond yields as measured by the Moody’s BAA bond yield and Treasuries (black line) or 3 month libor (yellow line). Both are already the tightest since the financial crisis and neither shows much room for manoeuvre. Longer dated bonds may rally, but we are pretty certain Libor is continuing to rise. Consensus suggest 2% plus by year end, which means that that those using leverage to buy fixed income products will struggle to deliver returns, certainly if volatility picks up.
With a likely shrinking of leveraged bond books, logic suggests that the underlying instruments may then be priced by ‘different hands’, i.e. investors rather than traders. Just as we previously discussed how the withdrawal of the Federal Reserve (Fed) from buying asset backed securities would likely lead to different hedging strategies (i.e. buyers would start hedging duration, which the Fed doesn’t do) we may see volatility pick up and the long ignored fundamentals such as inflation start to count again. Meanwhile, with the high yield bond ETF flat year to date while Treasuries are down almost 5%, there may be some rotation and thus spread widening.
The question is, will this spread to equities? Well, in my view yes and no. Yes in that it will likely affect rotation within markets, but no, I don’t think overall valuations are threatened (albeit allowing for some short term correction as discussed earlier). The fact that the bond analysts have spent the last decade referring to anything that isn’t a US Treasury as ‘risk assets’ has tended to mean that people expect equities to follow corporate credit, when at best it’s the other way around if at all. The very same phenomenon that has prevented traditional institutions from owning equities now means that those that do own equity are more focussed on growth and would likely need to see a much higher running yield from corporate debt to consider switching. Currently, even one of the more expensive markets like the S&P 500 is on an earnings yield (inverse P/E) of around 4.5%, higher than the equivalent corporate bond yield, while in Europe, ECB buying of corporate bonds has made the spread even wider in favour of equities. As for Asia, the dividend yield in many cases is higher than corporate debt let alone the earnings yield. Plus of course while the current co-ordinated economic growth makes corporate bonds less likely to default; it also makes equity dividends more likely to rise.
What we have seen however is the macro ‘punditry’ translate into sector and stock rotation within markets. Thus higher economic growth tends to lead to rotation away from ‘bond proxies’ and towards more ‘cyclical’ stocks and vice versa. As such we would have expected to see the sell off in bonds accompanies by a rotation to cyclicals and value stocks. And so it has proven. The next question therefore is, will this be sustained?
In my opinion there are a number of reasons to be cautious about interpreting the macro data as a reason to buy ‘cyclical’ stocks at these levels. First, many of them have run a long way already, helped by a scramble to get neutral by index aware funds, a classic case of appearing to take risk (buying cyclicals) when in fact the institution is actually reducing risk (flattening to the benchmark). Second, a lot of the apparent strength in commodities may be seasonal and not unconnected with Chinese New Year and there is a risk that this positive news not only fades but some weaker data acts as a catalyst for profit taking. As noted previously, one useful early warning indicator, the Baltic Dry shipping index which is a good proxy for international trade activity, especially in areas such as raw materials, has been weak recently and we also note one of the major linked commodities, iron ore has just come off a recent high, see chart 5.
Chart 5: Iron Ore. Short Term Top?
Source: Bloomberg, AXA IM, February 2018
This is not unusual. We can see that this time last year iron ore prices were strong but then did a pretty exact 76.4% fibbonacci retracement of their rally from the December 2015 lows and a full retracement of the rally that began in Q4 2016. So far, this latest cyclical rally has taken the iron ore contract from $441 to $628 and through its long term moving average (which is a positive sign). However, the rally looks to have stalled and the price is currently around $593. We would be watching the long term moving average – currently at around $518 for some support. If that breaks, then the risk is a move back toward $400, which of course would trigger a rapid reassessment of the cyclical growth story.
The other aspect of cyclical rotation we would worry about is that one of the signals – higher prices following higher economic activity tends to be greeted with an impulse to buy equities generally, when what it is more likely to actually reflect a shift in pricing power. This is important in the same way that higher bond yields are probably worse for credit than equities, so higher economic activity can actually often be worse for (some) equities than bonds. As with so much in corporate activity, at the margin, it’s all about the margin. Assume for example that there is a pick-up in wages. The normal response is that is great for equities as this means more demand for goods and services and thus a reason to buy consumer cyclicals. But what if the higher wages are mandated minimum wages (as is happening in parts of the US and Europe at the moment). Take a typical consumer facing business with perhaps 50% of its costs as wages, operating on a 10% gross margins which sees its wage bill rise 5% (as has just happened in California). Unless they can raise prices, that actually brings its profit margin down to 7.5% or in other words a 25% fall in profits. It doesn’t have to be mandated wages either – an increase in competition for staff can also drive up wages (or indeed other costs) in industries with no ability to pass them on. So here again, fundamentals are key. To date, especially in Asia, price levels have been as much about earnings as multiple expansion, but earnings momentum needs to be sustained.
As I finish writing this I am also putting the finishing touches to my presentations for a trip to Australia. This is an annual event following the Australian summer holidays and involves a stage, a large audience and a panel each of whom has 10 minutes to get across a view of the world (!). Aside from ‘where we are at the moment’ I am also highlighting some of the latest statistics on China and the way it is influencing economic activity and thus profitability and investment across the whole region. Chart 6 is just one chart that illustrates how on a conventional basis China is not only the second largest economy in the world by GDP, but that it is now bigger than the UK, France, Germany, Italy and Spain combined.
This is important when trying to make historic comparisons. As noted earlier, Asia is as cheap against the US as it was in the 1997 crisis, but to put it in some economic context, back in 1997, Chinese GDP was less than a trillion dollars. Last year it grew by more than a trillion dollars. Or to put it another way, last year China’s GDP grew by the equivalent of Australia.
Chart 6: China is simply too big to ignore
Source: IMF, AXA IM , February 2018
Moreover, as the orange bars show, on a PPP basis China is already the largest economy in the world. As we have noted on previous occasions, the Chinese middle class now number over 350m and with consumption being driven by 8-10% real wage growth rather than a traditional emerging market debt fuelled consumer boom (China’s debt ‘problem’ is in the State Owned Enterprises not the households). They want the same things the middle class wants everywhere, new and better housing, cars, education for their children, healthcare, travel, higher quality food and beverage. This is not just domestic, but globally. However, part of the problem for western companies is that they are consuming via mobile devices. It is estimated for example that Chinese consumers spend $3.2bn hours a day on mobile apps and spend $5.5trn with digital payments – 50 x the level that currently exists in the US.
Finally, a picture of the future. This is a real working driverless taxi. This week US company Waymo announced that it has already bought 500 of these Chrysler Pacifica minivans and will be buying thousands more as it brings its driverless taxis to Phoenix Arizona this year. It has already done enormous amounts of testing and is now ready to deploy.
Auto Mobility is here
Leaving aside the broader aspects of autonomous travel for a moment, this also raises a few short term practicalities. Firstly, if people are going to use autonomous taxis rather than own their own cars, then the probability is that most cars will evolve to be large people carriers rather than sports cars or sedans. Moreover these will be bought as fleets and will have a focus on economy and fuel efficiency rather than speed, as well as probably not having all the fancy high end high margin extras (beyond wifi) that auto companies are currently trying to push onto customers. This suggests a likely consolidation among manufacturers and a likely collapse in residual values for ‘old style’ cars, which comes at a time when a large number of auto loans are already underwater. Taking it to the next stage, what about rental car companies? On the one hand they may be able to compete and become more efficient by ‘home delivering’ your car autonomously, but on the other hand they are very vulnerable to residual values. While the world frets about China and its debt, this could be a debt problem worth paying attention to.
All data sourced by AXA IM as at Thursday 18th January 2018.
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