Weekly Market Review   April 27th 2019

In this Issue

  • MARKET TOP ?
  • IS THE RALLY OVER IN CHINA ?
  • WHAT TO EXPECT NEXT WEEK
  • THE WEEK IN REVIEW

MARKET TOP ?

Last week saw the Industrial Dow Jones and the Standard & Poor’s 500 indexes get extremely close to making a new all-time high and the NASDAQ Index actually recorded one intra-day.

Almost every economic indicator points to a recovery in the world’s second largest economy but the Chinese stock market tanked 5.5 % last week as China’s Politburo recommended prudence over additional economic stimulus.

Most equity markets have paused last week, or clearly lost momentum. The question then becomes : Are we reaching a major top in global equity markets ? 

In the US, the combination of important technical levels, excessive optimism and the end of the reporting season calls for at least a pause in what proved to be the fastest recovery ever in history.

The closeness to the All-time Highs recorded in 2018 and the fact that the Q4 2018 correction stopped at 20 % raises the question of whether the secular bull market that started in March 2009 peaked in January and September 2018 or whether we will see new highs in 2019.

The three main drivers of the rally of the first third of the year were the end of monetary tightening, a potential resolution of the US China Trade War and solid corporate earnings.

US corporate earnings came out on the better-than-expected side for 80 % of the companies having reported but that comes after weeks of analysts lowering their expectations.  

For Q1 2019 , based on the companies having reported to date, 78% of S&P 500 companies have reported a positive EPS surprise and 53% have reported a positive revenue surprise.

However, the blended earnings decline for the S&P 500 is -3.9% year-on-year, marking the first decline in earnings for the index since Q2 2016 

On March 31, the estimated earnings decline for Q1 2019 was -4.0%, explaining why the reported earnings exceeded expectations. Six sectors have higher growth rates today (compared to March 31) due to upward revisions to EPS estimates and positive EPS surprises.

For Q2 2019, almost 90 % of the S&P 500 companies having reported earnings have issued negative EPS guidance and only 10% issued positive EPS guidance.

Valuations are back in overvaluation territory, particularly in the tech sector where stratospheric valuations are still the norm despite a significant decline in earnings and revenue growth. 

Based on earnings reported to date, the forward 12-month P/E ratio for the S&P 500 is 16.8. This P/E ratio is above the 5-year average (16.4) and above the 10-year average (14.7).

By all metrics, corporate earnings will not be supporting incremental advances in the main indexes, especially if, as we expect, the US economy slows down further in the second quarter of the year.

The surprisingly strong 3.2% GDP growth reported on Friday for the 1st quarter hides the most significant bout of weakness since 2015. 

Furthermore, for the first time in many quarters, the labor market is giving signs of easing, a bad omen for an economy where consumption and consumer confidence are the main drivers of growth.

Filings for U.S. unemployment benefits rose the most since late 2017 last week. Jobless claims rose 37,000 to 230,000 in the week ended April 20, according to Labor Department figures Thursday that matched the highest estimate by economists. The four- week average, a less-volatile measure, increased to 206,000. The rise in claims for the week was the most since September 2017, according to the Labor Department.

. On the China-US Trade front, next week should be crucial as the final round of talks is supposed to take place before the two leaders maximo meet in the middle of May. Trade negotiators led by U.S. Trade Representative Robert Lighthizer return to Beijing next week as both sides work toward a face-to-face meeting between Trump and Xi to ink a deal.

In a highly unusual fashion, Chinese President Xi Jinping addressed some 40 world leaders at the Belt and Road forum in Beijing, but his speech may have been aimed more at U.S. President Donald Trump than at his audience.

Xi spent a large portion of his speech addressing Chinese domestic reforms, pledging to address state subsidies, protect intellectual property rights, allow foreign investment in more sectors and avoid competitive devaluation of the yuan.

All four are the key issues the U.S. is addressing in trade talks with Beijing.

China will “standardize the behavior of governments at all levels, clean up and abolish unreasonable regulations, subsidies and practices that impede fair competition and distort the market” said Xi Jinping 

Xi’s promises have been echoed by officials over the past few months and China has taken several steps to address U.S. concerns, including passing a new foreign investment law that bans forced technology transfers. 

China seems determined to finally solve the issue of its gap in global standards as perceived by the western economies. Chia aims at becoming a global and recognized player and position itself as the next reliable world leader.

The Trade War negotiations are a unique opportunity for Xi Jinping to achieve this official recognition as well as forcing the pace of reforms internally.

We are convinced that China will go further than the markets expect in the resolution of the Trade war, not as a sign of weakness but because it has all to gain form being seen and recognized as a reliable partner earlier than later by the community of nations.

In this context, China and the U.S. are probably coming close to a deal that could include a currency pact.  

As we had predicted all along Xi’s own words reminded his audience that there could be an agreement not to have competitive devaluation and that a stronger renminbi was more desirable than a weak one. 

The yuan climbed on Friday as the central bank set its daily reference rate at a stronger-than-expected level.

For the US equity markets, that could be a Buy the rumor – Sell the news kind of situation as the two leaders have worked consistently to build up positive expectations over the past four months.

For the Chinese stock market, the depth of the commitment and the assurances that the Yuan will not depreciate or could even appreciate may unleash a new wave of portfolio investment in  Chinese equities.

. In terms of monetary policy, the stronger than expected US GDP numbers for the 1st quarter fueled the debate on whether the FED would raise or lower rates in 2019.

Obviously this is a key issue as liquidity and exceptional liquidity for that matter is what has justified the leveled valuations of the US equity market in this bull phase. 

Monetary normalization combined with the Trade war is what sent the equity markets roiling in 2018 and the pause in interest rate hikes is what propelled them back up in the first quarter of 2019.

However, we are of the view that the key issue is NOT interest rates, as we do not see the FED raising or lowering rates in 2019, but inflation rates.

Liquidity and stock market valuations are more about real interest rates than about nominal interest rates. Negative real rates fuel higher asset prices while positive and rising real interest rates compete head on with asset prices.

The real danger for us in the US equity markets for the remainder if the year are a sharp decrease in inflation that would mechanically increase real interest rates and make US equity valuations less palatable.

Indeed, the sharp decline in Oil prices that we expect combined with less favorable US labor markets could push inflation gauges sharply lower in the coming quarters leading to our expected DEFLATION SCARE.

Another element that could come into play is a sudden degradation of credit risk perception as the excesses of US indebtedness come back home to roost. An increase in corporate default rates or significant downgrades by rating agencies could have the effect of raising long term corporate yields.

Finally, we are worried by the return of complacency and the excess of optimism at this juncture.   

Margin debt levels are at exceptionally high levels. 

Investor’s optimism is at record highs and actually much higher than at previous peaks 

And hedge funds are betting massively on an absence of volatility, usually a contrarian sign if history is any guide.

As equities surged to all-time highs, volatility has all but vanished. Hedge funds are betting the calm will last, shorting the Cboe Volatility Index, or VIX, at rates not seen in at least 15 years.

Large speculators, mostly hedge funds, were net short about 178,000 VIX futures contracts on April 23, the largest such position on record, weekly CFTC data that dates back to 2004 show. 

Commonly known as the stock market fear gauge, aggressive bets against the VIX are, depending on your worldview, evidence of either confidence or complacency.

In a nutshell, we feel that the US equity markets are at a critical juncture and that the environment calls for prudence.

Our preferred scenario is for a mild correction before anew attempt a new highs, but in the current environment, any negative piece of news could send the markets tanking.

IS THE RALLY OVER IN CHINA ?

Last week’s sharp fall in Chinese domestic equities ( -5.4 % for the main domestic indexes ) comes on the heels of a massive 35 % advance since the beginning of the year, making Chinese equities the best investment this year so far.

Chinese domestic investors are not the malls sophisticated in vectors and they are clearly momentum driven, showing a herd instinct that leaves little room for rational valuations and/or behavior.

The problem is that China’s stock market has reached a size that makes it an influential macro-economic factor and investors participation has become such that the gyrations of the stock market can have a significant impact on consumption and investments.

The best illustration of the phenomenon was the crash of 2015 that followed a massive and uncontrolled appreciation in 2014 and 2015, leading to an unwanted economic contraction afterwards. 

Ever since, the Government has tried to avoid excessive movement and over-speculation, leading foreign investors to call the market manipulated and preventing a faster inclusion into the global MSCI indexes.

After dramatically underperforming their U.S. counterparts for most of 2018, a year where Chinese equities fell by 25 % and returned to levels that were prevalent 10 years ago, they have once again been leading to the upside through the first four months of 2019.

After last week’;s sharp correction, the benchmark Shanghai Composite Index is up around 23% this year, still outpacing U.S. stocks.  The question that begs to be asked is whether last week’s sharp fall is the beginning of a sharp correction or just a bump in the road ?

Last week’s sharp fall was due to investors getting scared by the comments of China’s Politburo regarding the need for the Government to reduce the level of economic stimulus.  Investors were surely looking for an excuse to sell and reduce their margin long positions.  This is very visible in the behavior of individual stocks.

Like Japan in the 80s, today’s China is not like other markets. It does not work by the same “rules.”

Chinese equity markets are dominated by individual investors who care little about fundamentals and are looking to make significant quick bucks through margin accounts.  They follow rumors, brokers, and leverage.

As a result, market moves can be sharp and exaggerated in both directions.  The Government is fully aware of these traits and tries to manipulate the psychology rather than the market itself.  However, the Politburo did probably not expect to trigger such as sharp selloff on equities, even if it is quite happy to see the budding speculation being quashed.

A quick look at the chart below shows that – five separate times – Chinese stocks have delivered triple-digit percentage gains within 24 months.  

The rally of the first part of 2019 remains extremely muted when compared to past rallies and started at extreme lows of valuations.  Rarely does a stock market trade on a 1x book value, forfeiting all future earnings.

Moreover, the rally comes at a time where the Chinese economy is pulling out of its 2018 hole despite the Tarrifs implemented by Donald Trump’s Trade war.  This is in itself a major vestry for XiJing Ping’s administration and testifies of the efficiency of China’s baby step economic management.

More importantly, at 6.3 % economic growth and 15 to 20 % return on equity, corporate earnings should continue to grow and in fact even accelerate as China’s consumption grows even bigger.  At current levels, valuations are far, very far from the peaks of the past and there is nothing on the economic horizon that would justify caution.

Quite the contrary, next week’s expected resolution of the US Trade War may actually bring good news. It was significant to hear Xi JingPing addressing all the main concerns of Donald Trump in a speech that was not destined to the US President.  China wants a deal and will have one, even if the one who really needs it today is Donald Trump. 

China may be on the verge of becoming a “respectable partner”.

That will unleash a new era where investing in China may become THE Thing.

 In a recent interview with Business Insider, Karen Karniol-Tambour – head of investment research at Ray Dalio’s Bridgewater Associates – said few opportunities are more compelling for U.S. investors than China right now.

A recent landmark decision by global index provider MSCI will cause up to $2 trillion to flow into domestic Chinese stocks over the next several years.

A clearance from the Trump administration and strong and verifiable commitment by China NOT to devalue its currency will unleash powerful flow of funds into Chinese equities as Foreign investors increase their proportion of Chinese equities from 5 to 15 % of their global portfolios.

As a result, A-shares are likely to soar, almost regardless of whatever else is going on in China or the global economy. 

“The thing that makes this opportunity so compelling is that, for many investors, this a market that essentially didn’t exist,” Karniol-Tambour said. “If you believe in diversification, you’re not going to get a lot of opportunities where such a large market opens up.”

WHAT TO EXPECT NEXT WEEK

THE US DOLLAR 

As we predicted, the dollar rose to near two-year highs, leaving many scratching their heads. To many, it’s down to signs the U.S. economy is still growing strongly while the rest of the world – Europe and Japan in particular is losing steam. 

Indeed , Wall Street is busy making new highs day after day, US corporate earnings were stronger than expected and the 1st quarter GDP came out at 3.2 % beating all expectations even if the strength was concentrated in the volatile inventories and export components.

The euro tumbled to 22-month lows against the dollar and investors are preparing for more, buying options to shield against further downside.

U.S. data need to keep surprising on the upside or even just meet expectations for the Dollar strength to continue. The International Monetary Fund sees U.S. growth at 2.3 percent this year. For Germany, the forecast is 0.8 percent. The U.S. economy’s strong health has given rise to speculation the Fed might resume raising interest rates. 

We doubt it and in fact expect US economic numbers to be on the weak side after the strength of the 1st quarter… But as other countries — Canada, Sweden and Australia being the latest — hint at more policy easing, there seems to be one way the dollar can go. Up.

Technically, the break of the US dollar Index above 97.5 points to an acceleration towards 100, the EUR is settling in a new trading range between 1.12 and 1.10, Swiss francs should rise firmly above 1.02, the Japanese Yen could well break above its long term triangle above 112 and the expected resolution of the China _US Trade War next week could people the Chinese Yuan higher against all currencies.

Another crisis may be brewing in emerging markets. With the Turkish lira and Argentine peso both sharply weaker.

Whether you look at foreign exchange markets or default risk indicators, it’s been a particularly rough week for Argentina and Turkey. Both nations’ currency and credit default swaps are trading at their worst levels for the year. 

The situation is particularly alarming for Argentina, where the investor-perceived probability of default has shot up to over 60 percent. The country’s April 2021 bonds are yielding an eye-popping 20 percent.

All this is taking place in the context of a government elected on a platform of economic and financial reform, benefiting from exceptional financial support from the International Monetary Fund, and having recently successfully completed a mid-course IMF program review. Y

Argentina is increasingly suffering through a cycle of financial disruptions, economic contraction, debilitating inflation and weakening creditworthiness ahead of October elections that are shaping up as a referendum on President Mauricio Macri and his reform program.

JAPAN’S NEW ERA

Next week ends three decades of Japan’s Heisei era. Heisei, or Achieving Peace, began in 1989 near the peak of a massive stock market bubble and closes with the country trapped in low growth, no inflation, and negative interest rates.

The new era that dawns on May 1 is called Reiwa, meaning Beautiful Harmony. It begins when Crown Prince Naruhito ascends the Chrysanthemum Throne. But what is harmony? Investors want to see is a bit of economic growth and inflation to shake up the status quo that has characterized the lost decades.

The Bank of Japan’s stimulus toolkit to revive a long-suffering economy is anything but harmonious and yet it’s set to stay. The central bank confirmed recently rates will stay near zero for a long time. 

The coming days may not be harmonious or peaceful for currency markets. A 10-day Golden Week holiday kicks off on April 29 and investors are fretting over the risk of a “flash crash” – a violent currency spasm that can occur in times of thin trading turnover.  We see the Yen breaking out of this major triangle that has been in place  very soon.

The question is : In which direction ?

The year has already seen two yen spikes and many, including Japan’s housewife-trader brigade – so-called Mrs Watanabes – appear to have bought yen as the holiday approaches. 

Their short dollar/long yen positions recently reached record highs, stock exchange data showed. The market is set on the idea that the Japanese Yen has only one way to go and the is up.  

WE STRONGLY DISAGREE AND SEE IT FALLING SHARPLY TOWARDS 120

CORPORATE EARNINGS 

Quarterly earnings were supposed to be the worst in Europe in almost three years, but with a third of results in, things are looking a little rosier. Two-thirds of companies’ results have beat expectations, and they point to earnings growth of 4.5 percent year-on-year. Financials have delivered the biggest surprises, according to analysis by Barclays.

That might just show how low expectations were.  In fact, analysts are still taking a red pen to their estimates.

The latest I/B/E/S data from Refinitiv shows analysts on average expect first-quarter earnings-per-share for STOXX 600-listed companies to fall 4.2 percent. That would be their worst quarter since 2016 and down sharply from an estimated 3.4 percent just a week earlier.

Those estimates may end up being a little too bearish as earnings season goes on, quelling worries that Europe is heading toward a corporate recession. GSK and Reckitt Benckiser will give the market a glimpse of the health of the consumer products market and spending on everything from toothpaste, washing powder and paracetamol.

In the US, earnings have been uneven, even if on the positive side.  There again, expectations were extremely low and 80 % of te companies that have reported their earnings did beat the consensus expectations.   

However, the picture was extremely uneven with industrials and consumer goods posting Medicare results while internet and technology companies reported strong positive surprises.  Next week’s Litmus test will be Apple Inc. and Google’s results.

UBER HITS THE ROAD

Over the past decade, Uber Technologies Inc. proved itself to be one of the most prolific young fundraisers ever. It pulled together more than $20 billion from private investors. 

After burning through more than half that amount in just the last three years, Uber will soon see whether it can recreate that magic on the stock market.

The ride-hailing company entered the final stretch of the ultimate capital-raising exercise on Friday, when it disclosed details of an initial public offering expected to net the company and its backers another $8 billion or more. 

The IPO will value the company at US$ 91.5 billion, making it the biggest IPO by far this year.

Executives and bankers plan to hit the road next week to promote the stock to public investors and then ring the bell on the New York Stock Exchange floor on May 10, when the shares start trading, according to a plan obtained by Bloomberg.

THE WEEK IN REVIEW

CURRENCIES 

Another strong week for the US dollar which added 0.5 % against most currencies. It was supported by strong US corporate earnings and an unexpectedly strong US GDP for the first quarter of 2019.  Technically, the break in the DXY US dollar index is a bullish sign opening the way to 100 and 103.

The Euro may be establishing a lower trading range than the one seen this year, with risk that the lower end extends below the $1.10 psychological support area and toward the levels seen around the French 2017 elections.  Spain’s elections may yield a hung parliament adding uncertainty to the common currency and the ECB meeting on May 1st will only confirm the unwillingness of the Central Bank to move from its extremely accommodative stance.

A new crisis may be brewing in emerging markets with the Argentinian Peso falling by 8 % and the Turkish Lira losing -2.14 % of its value. 

EQUITIES 

Chinese stocks collapsed 5 % last week as investors took fright form the comments of the Chinese Politburo recommending to the Government not to stimulate the economy further.

Meanwhile, strong Corporate earnings in the US technology sector pushed the Nasdaq to a new intra-day all-time high. 

European stocks were mixed while Japanese stocks were getting ready for an extended Golden Week.

WE REMAIN CAUTIOUS ON EQUITIES AT CURRENT LEVELS AND EXPECT A CORRECTION AHEAD

COMMODITIES  

A major top was recorded in OIL last week as surging American crude oil production rose by more than 2 million bpd to an unprecedented 12.1 million bpd.  After eight weeks of build-up, inventories fell 8 million barrels to the elevated level of 445.87 million barrels. 

Technically, Oil recorded the first significant top since the 35 % rally began in December 2018.

Metals were soft overall while Gold and Silver are attempting to find a bottom.

BONDS

Bond yields were lower across the board as inflation remains tamed and US employment numbers came out on the weak side for the first time in a while. Declining oil prices will probably probably take inflation numbers lower in the months to come.