Despite the current doom and gloom, we stick to our call for a sharp year-end rally in equities.
The US dollar will succumb to an economic slowdown and extremely long positions.
OPEC Oil cuts won’t be enough to prevent oil prices from falling further
Bond’s bear phase is over for now and the FED may actually hold its horses next week.
A relatively calm week ended with a 495-point fall in the Dow Jones Industrial Index on Friday, taking almost all equity markets with it.
The trigger was weak economic news coming out of China and added pressure on Donald Trump in the USA.
China’s economy slowed again in November as retail sales and industrial production weakened, creating a challenging backdrop for policy makers who gather next week to set the tone for the year at their annual Economic Work Conference in Beijing.
Industrial production growth decelerated to 5.4 percent, below all 38 economists’ estimates. Retail sales — a pillar of support for the economy — posted the weakest performance since May 2003, rising 8.1 percent from a year earlier.
It wasn’t all bad news though. Fixed-asset investment growth firmed, expanding 5.9 percent in the first eleven months of the year, and the surveyed jobless rate dropped marginally to 4.8 percent. That suggests stimulus to cushion the slowdown is beginning to take root.
Carnage in Equities
As of Friday’s close, the S&P 500 was down 11.3 percent from its September close, with more than half its constituents reaching bear-market losses of 20 percent of more.
The Nasdaq 100 has fallen 13.9 percent from its record close in August, while the Russell 2000 Index of small-cap stocks has lost 19 percent, leaving all three with declines for 2018.
US$3 trillion in value have been wiped-out in the US stock market with a bloodbath in banks and transportation stocks.
Many high profile fund managers are closing shop having delivered extremely negative performances this year, one of their worst year on record. 177 hedge funds have closed down in 2018 and there are very few portfolios or funds delivering positive performances this year.
Investors had hoped for a year-end rally to save the day and took to much risk, but liquidation has been massive in the past two weeks.
When stocks rallied in January, investors rushed in. In a single week, inflows totaled more than 0.25% of all assets, the most in more than a year.
Last week, according to Lipper, investors pulled more than $46 billion from equity funds this week. That’s the most in at least 15 years, and it’s still the most when adjusting for the growth in assets. The outflow was more than 0.44% of total assets, eclipsing the previous record of 0.39% from August 17, 2011.
It’s not unusual to see large outflows in December – whether for tax loss harvesting, tax bills, or other reasons, mid-December, but this months outflows are exceptional and equities always rallied after such large outflows.
One of the many reasons that investors seem to be unnerved about this selling is because it’s unusual. We already saw compelling signs of extreme pessimism in the past few weeks, and yet here we are at new lows.
Most fundamental data continue to be decent. And it is December, usually the best month of the year.– we don’t often see such heavy selling at this time of year.
It is clear that few investors want to hold over the weekend. During the past 8 weeks, the S&P’s average return on a Friday is -0.9%, the worst in 7 years and among the worst since 1950.
A loss like Friday, more than 1.75% and to a 6-month low, shows some sense of panic from investors.
Stocks are not acting well, at all, and everyone can see it. Failure to hold any intraday gains is highly unusual and another sign of extreme discomfort with stocks.
So where does all this volatility come from ?
The truth is that investors are no longer patient. They did tolerate higher interest rates and accepted the fact that corporate earnings probably peaked, but strong labor markets and wages call for economic sustainability.
Moreover, the 30 % collapse in Oil prices bodes well for inflation being contained in the coming future, a comforting element as far as interest rates are concerned.
Investors could have lived with a healthy and orderly correction in valuation.
But in the past few weeks, the financial markets have taken a panicky bias with massive liquidation and large short positions being put in place.
Hedge funds and computer driven traders are positioning themselves for the year-end and only to cut their long positions at the first sign of weakness.
One of the most obvious cause is the market’s increasing lack of tolerance for the political drama surrounding Donald Trump’s presidency, which in recent days has become all the more acute.
Even as the U.S. and China have taken positive steps on trade in recent weeks, amplified political woes surrounding Trump mean Wall Street can no longer ignore what’s happening in Washington, especially as investors keep an eye on weakening economic data in China and Europe.
Signs are mounting that the market infatuation with the current president may be wearing off.
The S&P 500 hasn’t been able to gain its footing since September, lurching from one painful rout to the other. Most of the gains from Donald Trump’s tax cuts have been eroded and investors are blaming the uncertainties created by the Trade Wars for the markets jitters.
And the political peril is mounting such that online betting site PredictIt now has the odds that the House of Representatives passes articles of impeachment against the president approaching 50 %.
President Donald Trump’s trade war with China was the top 2019 concern
cited by US economists.
85% of economists surveyed by the Wall Street Journal also said risks for
the US economy are tilted toward the downside, the most in at least three
Only four economists agreed with Trump’s suggestion that the Federal
Reserve is the biggest threat to the economy.
Some of the country’s top economists are the most worried they’ve been in
years about the US economy.
And their biggest fear? President Donald Trump’s trade war with China
All this to say that the environment looks bleak and that investors are worrying about a significant break down in equities.
In fact their real worry is whether the weakness in stocks heralds a coming recession and that the bear market has just started.
Value is back ?
Value has been somewhat restored in US equities, even if betting that valuation expansion will take place in the future is a far fetched bet. Far from it, valuation contraction should continue, but the pace should not and deserves not to be as violent or even linear.
After a 30 % correction in Asian markets, value is now truly compelling in Chinese and Asian equities.
Are equities heralding the next recession ?
At the beginning of the year, every commentator was excited about growth and earnings as the Donald Trump’s Tax cuts were coming into play.
We argued many times that reducing taxes at the peak of an economic cycle was a recipe for disaster as it amounted to a shot in the arm of an already hyped economy and would ultimately leave the state with deficits that would have te be financed later either through tax increases or through a decrease in expenditure.
So, at some point in the future, the conditions are definitely in place for a significant slowdown of the US economy or maybe even a recession.
However, it probably won’t be just now and probably not in 2019
Looking at the S&P 500’s downward trajectory over the last 12 months, David Kostin, Goldman Sachs’s chief U.S. equity strategist, reckons the market is already pricing in zero economic growth.
That’s too pessimistic, he said, as the firm sees a 2.5 percent expansion next year and we agree with this scenario as consumption is going to remain strong going into 2019.
Robert Buckland, Citigroup’s chief global equity strategist, employs a similar approach in assessing the future of corporate profits. The MSCI World All-Country Index is now pricing in a 1 percent decline in earnings in 2019, below the 5 percent increase that he and his colleagues forecast.
Their models suggest that global equity may now be too bearish on the earnings outlook and we agree on that as well, particularly as we expect interest rates to plateau very soon in the US and to decrease in China
Since Bloomberg began tracking the data in 1992, the S&P 500 at this time of year has stood at an average of 17.4 times income that ended up materializing in the next year. This is a statistical measurement of what happened in the past.
Assuming stocks are now valued at that average, it would equate to the market predicting $152.50 a share in 2019 earnings for the S&P 500, not the $174.50 estimated by analysts.
In other words, while Wall Street predicts 9 percent profit growth for next year, the market is pricing a 5 percent decline.
And assuming earnings do actually collapse, the collapse is ALREADY priced in.
Sure, markets overshoot, and sentiment gets carried away.
Corrections like this one have occurred six other times since the bull market began in 2009. They all sparked growth scares. But none of them a recession.
Moreover, monetary policy is still accommodative with real interest rates still in negative territory, even if the FED is to raise rates one more time next week.
We have just witnessed the liquidation phase of the first leg of the global bear market that started in January 2018 and are about to start the Bear Market Rally
We were amongst the very few commentators to predict the top in global equities in 2018 and call the end of the secular 2009 -2018 bull market. Global equities peaked on January 26th 2018 and US equities peaked on September 20th 2018.
We warned about the October correction ahead of time and were surprised by its violence, but in hindsight, considering the extremes levels of optimism and participation in the market, the sea-change in sentiment had to be devastating.
We were also amongst the very few, if not the only, commentators to predict the end of technology stocks back in March and April of 2018.
We see the moves of the past few weeks as the panic and capitulation phase of the first leg of the Bear market.
We see equities bottoming out next week and staging a sharp rally into the year-end as short covering will be very strong. This rally will carry on in the first quarter of 2019 as subdued inflation numbers will keep the FED and bond vigilantes at bay.
In fact we believe that the bond market correction is over and that bond yields will go south in the months to come.
We have numerous indicators showing that pessimism is at an extreme in equity markets and that the volume of hedging and short positions is now at levels that usually preceded significant rallies.
Pessimism is at an extreme and the current support levels are solid.
The trigger for the rally could be a dovish FED and / or significant changes coming out of China’s Annual Economic conference next week.
We would not be surprised to see the main indexes closing the year in positive territory.
Asia and China are already showing positive divergences and relative momentum.
They will outperform in the coming bull phase.
Over the past 2 weeks we have seen more and more breakdowns in USD key pairs, whereas the DXY Index has been relatively stable.
Last week we highlighted the fact that via the index weight of 83% it is the EUR, GBP and JPY that have been holding the DXY relatively stable, where we effectively need to see a break of the neckline of its inverted head & shoulder bottom at 1.1450 in the EUR to see real pressure unfolding in the DXY
This picture has not changed and last week the DXY remained range-bound as panic in equity markets sent the Japanese Yen flying and Brexit uncertainty sent the GBP falling.
But wit economic momentum waning, equity markets falling, oil prices collapsing and trade wars taking their toll on investments, we continue to see the USD toppish and set for a signifiant corrective setback into Q1.
We have recommended investors to BUY the EUR at 1.13 and expect the European currency to see 1.16 and probably 1.18 before the move is over.
The market is overwhelmingly long US dollars.
The decision of the EDCB to end its bond buying program will have an effect on European bond yields.
Watch next week’s China’s Annual economic Conference for strategic directions on the CNY.
These are exactly the the forums where major strategic decisions are made in China – instead of Tweets in the USA – and China’s desire to end the Trade war and focus on internal growth may well lead them to announce a desire to let the YUAN appreciate in the long term.
Oil will fall further
Oil was down -2.6 % last week despite OPEC’s agreement to cut production by 1.5 Million Barrels/day. The market is not convinced that OPEC and its allies’ supply cuts can revive the oil market as it’s being countered by surging U.S. production.
The Bank of Russia cut its crude price outlook for next year to $55 a barrel from $63 on higher supply risks, mainly related to “fast output increase” in America, according to Governor Elvira Nabiullina.
Just a week ago the country’s Energy Minister Alexander Novak brokered a deal that led to the so-called OPEC+ group agreeing to cut production by 1.2 million barrels a day in an effort to boost prices.
Crude remains stuck in a bear market, trading around $60 a barrel in London, despite the larger-than-expected output reduction.
While most, including the International Energy Agency, expect the curbs to reduce global stockpiles in the first half of 2019, resultant higher prices could help American drillers boost production.
OPEC kept 2019 forecasts for global oil supply and demand mostly unchanged in its most recent monthly report this week. However, it said production from outside the group, powered by U.S. shale drillers, is poised to expand 2.16 million barrels a day next year, faster than the 1.29 million a day increase in demand, the report showed.
U.S. oil production is expected to top 12 million barrels a day next year, up from 10.88 million in 2018, according to the Energy Information Administration.
Oil was up 30 % year to date on September 1st 2018. It is now down 11.3 % having lost 33 % of its value.
OPEC is losing its grip on the market, Qatar has left OPEC, America is the world largest producer of oil now and shale oil provides unlimited supply at a time where clean energy production, Electric vehicles and the war against plastic containers are all pointing to a massive decrease in final demand for oil in the years to come.
Oil prices have been disconnected from real supply-demand for way too long with speculators and States manipulating the prices of oil as they saw fit.
The best illustration of the matter being the fight of words between Saudi Arabia who wants high oil prices to finance its strategic changes and America where Donald Trump wanted lower oil prices to have less inflation and lower interest rates.
It all ended when Saudi Arabia has to yield in following the blunder of te assassination of Jamal Khashoggi in Turkey. From that moment, the support of Donald Trump to Mohamad Bin Salman was conditioned to lower oil prices… and oil prices suddenly collapsed.
The euro-area economy is closing out 2018 on a gloomy note, echoing a trend of weaker global growth from China to the U.S.
A gauge of manufacturing and services in the euro region unexpectedly dropped to its lowest in just over four years in December. While the drop was driven mainly by France where the “Yellow Vests” movement led to a contraction, there’s also signs that underlying momentum is dropping off.
The euro-area composite Purchasing Managers’ Index gauge fell to 51.3 in December from 52.7 in November, missing economists’ forecast for a slight rise.
But political turmoil alone can’t account for the weakness that has characterized the euro-area economy since early this year, with trade tensions posing a headwind to investments across the globe.
The decline means the euro-region number has now fallen for nine months this year. The euro was down on the news but closed the week above 1.13
In China, figures on Friday showed slowing production growth and retail sales. The continued deterioration in economic numbers is forcing
policy makers to admit to a new reality after clinging for months to a narrative that the slowdown would prove temporary.
Next week’s Annual economic conference should deliver strong strategic messages for the future course of the Chinese economy and significant measures to boost demand, probably on the taxation side.
Companies are worried about the global economic and political climate, with trade wars and Brexit adding to increased political tensions.
We called a major bottom in US yields in 2016, and recommended that investors remained out of bonds altogether over the period.
We expected this bottom to be the basis for a major corrective yield rebound in line with the resurgence in inflation.
From a macro standpoint this anticipated rebound in yields was the basis for our suggested reflation cycle and the wave 5 bull cycle in equities with a comeback of inflation and cyclical leadership.
In our SEVEN INVESTMENT CALLS FOR 2018 we expected US 10-year bond yields to rise above the 3.00% threshold, which was and still is a very obvious long-term resistance, as it is de facto the neckline of a major potential double bottom as part of a secular basing process in yields.
One of the things that had prevented us form going back into bonds all over 2018 has been the sharp increase in oil prices from December 2016 to September 2018 and the strength of the US labor market.
With the October break down in crude oil and te spike in corporate yield spread. – see our November piece on TIME TO LOCK IN HIGH YIELDS – all the elements are in place for a more bullish view of bonds markets in general, even if the ECB finally confirmed that it would end its quantitative easing.
The break of the 2016 upwards trend in US inflation expectations is clearly there and the next question is whether the FED will continue raising rates at the same pace.
Falling stock markets, Trade wars uncertainties, a collapse in global investments and lower oil prices are all painting a weaker outlook for Federal Reserve officials to ponder when they hold their last monetary policy meeting of 2018 next week.