There’s no doubt the post-Christmas rally in risk assets has been impressive. Since the December 24, 2018 bottom in the S&P 500®, US stocks are up 18.8%. Globally based on the MSCI World Index,1 the boom has been 16.5%. Emerging markets, you ask? Up 11.8%. In bonds, high yield spreads have rallied over 140 bps while US investment grade bonds have rallied 27 bps. (All data in US dollars as of Feb. 26, 2019.) All told, not too shabby.
It would be easy to characterize this rally using any of the old Wall Street saws – go with the flow, ride the wave, don’t fight the tape, etc. However, our skeptical nature compels us to reexamine how we got here and explore the environment in which this rally is occurring.
The V-Shaped Selloff and Recovery
In retrospect, the Q4 selloff that took stocks down doesn’t seem too hard to explain. Start with stretched (but not exorbitant) valuations on risk assets, add a decelerating global economy, and throw in a tin-eared Federal Reserve that looked dead-set on continued tightening. Voilà, the bottom falls out. Then a Christmas miracle occurred. Markets pulled a 180. After the nearly 20% selloff, equity valuations looked downright reasonable – maybe even cheap. The Fed, spooked by its own power over financial conditions (falling stock prices and a rising US dollar). started backpedaling like an NFL cornerback. Meanwhile, with all eyes on stocks and the Fed, the US economy quietly began to buck the global deceleration trend with some decent macro data. A perfect recipe for a 9-week winning streak in US stocks, leaving them oddly close to their mid-September highs. While we certainly didn’t predict a knee-jerk V-shaped recovery, the elements clearly fell into place to create one.
Enough with the history lesson. Now we have to ask, “Does this rally still have legs?” (Usual caveat: We have no idea and neither does anyone else.) Higher equity prices never surprise us because, historically speaking, the market has gone up more often than not. However, with the “V” in place, we can now see contradictions brewing that would argue for tougher sledding ahead. With risk assets in full-blown euphoria mode, several factors are beginning to concern us:
#1 – The rally in risk assets isn’t being confirmed by nominal or real interest rates. Since the Christmas Eve bottom, real rates, as a proxy for growth – measured by US Treasury Inflation-Protected Securities (TIPS) yields – have been trending in the wrong direction. When stocks go full risk-on, bonds should be at least somewhat risk-off. This prompts the question: Does the bond market know something the stock market doesn’t? Perhaps the equity optimism is showing up in the yield curve? Nope. The spread between 10-year and 2-year Treasuries hasn’t budged since the rally began.
Source: Bloomberg, Natixis Investment Strategies Group, December 24, 2018 – February 26, 2019 (daily)
#2 – The US economy may no longer be bucking the slowdown trend. As we noted before, while the global economic deceleration solidly took hold in Q4, the US was still the “cleanest dirty shirt” versus much uglier data coming from China and Europe. Today, we’re not so sure. December retail sales were unbelievably bad – that is, so bad we don’t believe them – hopefully skewed by the government shutdown, bad weather, and/or year-end seasonal adjustments.
However, this list continues. Historically low jobless claims have probably bottomed, durable goods orders show no revival in capex spending, the housing market remains broadly soft, and the ISM Composite2 (an indicator of manufacturing plus services) fell to its lowest level in over a year – although still a respectable 56.7. (50.0 divides expansion from contraction.) Moreover, the Leading Economic Index (LEI)3 has effectively flatlined since the end of Q3. To cap this set of trends, we note that the Citigroup US Economic Surprise Index4 skyrocketed alongside stocks in January but has plunged in February while stocks continued to make new highs.
Source: Bloomberg, Natixis Investment Strategies Group, July 1, 2018 – February 26, 2019 (daily)
#3 – Finally, we’d be remiss if we didn’t highlight that while stocks have been surging YTD, calendar year earnings estimates for 2019 and 2020 have been sickly. Again, the dimming of corporate prospects rightly coincided with the selloff in Q4. Having said that, the post-Christmas rally certainly hasn’t been justified by an improvement in the earnings outlook. Quite the contrary, the degradation in earnings has only picked up speed since the rally began. To be sure, perennially optimistic analysts see earnings growth of over 10% YoY from 2019 to 2020, but that’s almost certain to shrink in a global economy where nominal growth is closer to 5%–6%.
Source: Bloomberg, Natixis Investment Strategies Group, July 10, 2017 – February 22, 2019 (weekly)
The combination of rising stock prices and falling earnings estimates has goosed P/E ratios, with the S&P 500®5 rising from a cheapish 14.8x to a considerably less cheap 16.7x – more than a 10% jump in valuation multiples since year-end. Overseas, the STOXX® Europe 6006 multiple has expanded from 12.0x to 13.7x. Neither of these metrics looks overly expensive, but stocks will need a stronger catalyst to keep moving higher as the air gets thinner.
So Now What?
For all our concern, we aren’t turning bearish – at least not yet. Again, we don’t like the odds of betting against a global economy that is still growing, albeit at a considerably slower pace. Moreover, we wouldn’t be surprised by some additional sentiment-driven upside if Brexit gets delayed (our base case) or Trump and Xi continue to show nominal (if not real) progress on trade.
However, before we conclude that this market still has decent legs, we’d like to see equity prices supported by stronger macro data, lifted by better earnings trends, and confirmed by stable-to-rising yields. Until that happens, life after the “V” may be more of a grind.
2 The Institute for Supply Management (ISM) Manufacturing Index is an indicator of recent US economic activity that accounts for new orders, production, employment, supplier deliveries, and inventories. The index is often referred to as the Purchasing Managers’ Index (PMI).
3 The Conference Board Leading Economic Index (LEI) is a US economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a non-governmental organization, which determines the value of the index from the values of ten key variables.
4 The Citigroup Economic Surprise Indices account for objective and quantitative measures of economic news. They are defined as weighted historical standard deviations of data surprises, comparing actual releases against Bloomberg survey medians. A positive reading of the Economic Surprise Index suggests that economic releases have been on balance beating consensus.
5 The S&P (Standard & Poor’s) 500 Index is an index of 500 stocks often used to represent the US stock market.
6 The STOXX® Europe 600 Index is derived from the STOXX® Europe Total Market Index (TMI) and is a subset of the STOXX® Global 1800 Index. With a fixed number of 600 components, the STOXX® Europe 600 Index represents large, mid and small capitalization companies across 18 countries of the European region: Austria, Belgium, Czech Republic, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the United Kingdom.
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