Fra JP Morgan
Equities had a meaningful rebound from the February lows, and we now find many who didn’t want to add at the time, are looking to enter the market at these levels. Indeed, pundits are urging investors to “chase performance”. We believe that this would be a mistake; complacency has crept into the market again, technicals appear overbought and the upturn in activity appears to be stalling.
- SPX RSI has recently hit high 60-ies. Proportion of bullish investors has shot up, proportion of bears has come down to 6-month lows. Vix is not far from the year lows. Skew and put/call ratios have normalised. Investors are not short anymore – HF beta has moved from -18% at lows in February to +22% currently.
- There are signs that the nascent stabilisation in activity, which started in February and helped equities bounce is already losing momentum. A gap has opened up between US CESI and SPX. Philly Fed has come down, as did US flash April PMI. Eurozone PMIs are not reaccelerating and credit impulse is weakening. Chinese Q1 data improvement was to some extent base effects driven, and policy support is now being scaled back. Real steel demand in China is significantly down again. We do not expect the restocking phase to last for long.
- EPS revisions remain in negative territory. Consequently, P/E multiples have re-rated substantially, with the 2016E P/E for S&P500 up 8% ytd, from 16.4x to 17.7x now.
- The positive market impact from the policy actions is likely behind us. This was driven by the change in Fed’s reaction function, doubling down by ECB and the turn in many EM central bank outlooks. In fact, expectations have shot up so much now that central banks are able to disappoint again – case in point is last week’s reaction to BOJ inaction. The turn in the USD is an important positive for EM, where we are OW EM vs DM this year, but it pressures Japan and Eurozone. Inflation forwards are remaining subdued.
- Strong April seasonals were a big help, where April was the best-performing month of the year historically. However, we are now entering typically poor seasonals, May and the summer.
Rather than chasing the recent rally, we believe that investors should look to fade it. In terms of equity allocation, we are UW equities in balanced portfolios for ’16, our first UW equity allocation since 2007. We cut our multi-year, structural OW stance on 30th Nov and are this year OW credit vs equities.
Matejka then explains why the upside potential from here is now limited:
There is a reason why equities didn’t go anywhere for a while now. MSCI World has not performed over a trailing 12-month and even 24-month timeframe, even though monetary policy was getting ever more supportive during this period. It appears that easy policy is not enough, we believe a sustained pickup in activity is needed to push stocks higher. This will remain elusive in our view, and we advise to keep using rallies as opportunities to reduce. Medium term:
- Equity valuations are not offering much room for error. Global P/E multiples have moved to outright expensive territory. The P/S metric is higher today than it was at any time in the ‘07-’08 period, also outright expensive. Peak P/S on peak sales? Bond yields are staying low, but at some point the market will have to look for a convergence between nominal bond yields and nominal growth rates.
- The gap between credit spreads and equities remains significant. In addition, supply of credit is getting worse – US bank lending standards have tightened for three quarters in a row. Demand for credit is falling, as well. This is the case for consumer too, where US consumer credit growth is the weakest since ‘11. US net debt-to-equity ratio is at the top of the historical range, much higher than it was in ’07.
- US profit margins are deteriorating. Profitability improvement was one of the key drivers of the seven-year equity rally. This might be finished, as the profit margin proxy – the difference between corporate pricing and the wage growth – turned outright negative in Q4 for the first time since 2008. Buybacks have flattered earnings for a while now, but we would be surprised if these stay a potent support. Buybacks as a share of EBIT are at historical highs, similar to the levels seen in 2007.
- Growth – Policy trade-off is poor. Global economic activity remains subdued, and at the same time, the Fed is not injecting liquidity into the system anymore. The best of policy support is behind us. In fact, if we are going to start the next downturn from a point where Fed was not able to unwind more than one or two of the past interest rate cuts, the hit to investor confidence would be significant, in our view.
- Structural Chinese backdrop remains challenging, in particular in terms of credit excess. Sentiment on the space had a U-turn recently. Only 3 months ago it was an unanimous view that CNY had to depreciate again. Right now there is an almost unanimous view that downside risks are successfully pushed out. Complacency coming back?
Finally, Matejka focuses on the one risk factor he believes is the most relevant one: sliding US profits, and the threat of stagflation.
- Consensus view is that the US backdrop remains the key area of support, with most seeing US consumer as resilient.
- Our concern is over the reversal of the following three powerful forces that led to the tripling of S&P500 over the past seven years: 1) profit margins moving from record lows since World War II to record highs; 2) HY and HG credit spreads tightening dramatically; and 3) the Fed expanding its balance sheet.
- All three of those drivers are finished from a medium-term perspective. US HY credit spreads have widened since June ‘14, and this move is not only due to the Energy sector. Ex-Energy, spreads are 270bp wider, in effect they doubled. US corporate balance sheets have deteriorated, in contrast to Europe. Profit margins are coming under pressure, given signs of increasing wage growth and weaker top lines than expected. Productivity is staying low, driving ULCs higher. The NIPA profits data for Q4 has shown significant weakening in all the divisions: domestic, foreign, financial and non-financial earnings.
- Profits and credit conditions have tended to drive both capex and the labour market. This is the conduit through which the weakness could spread to the rest of the economy, in our view. We note that the lead-lag was typically substantial, of the order of 2-4 quarters. Still, we believe one should be cutting equity weight before the weakness becomes obvious. The equity market is clearly far from pricing in much of the risk of broader economic slowdown, in our view. The US consumer cyclicals sector remains the strongest performer in this bull market. In fact, Consumer Discretionary sector is still holding up well this year and car sales are near record highs. If the economy does weaken toward the year-end, this would likely have a very material impact. This is especially as the Fed might be out of the picture given the timing of the US presidential cycle.
So first it was Deutsche Bank (by way of Joe LaVorgna) that became one of Wall Street’s biggest bears; now it is JPM’s turn. Perhaps Matejka’s appeal is genuine – we don’t know. However one thing is certain: when Goldman also joins the chorus of ever louder sellside bears, that will be the time to load up the truck with 3x leverage.