Correction within a Bear Market

Since September 20th 2018, more than $10 trillion of wealth were erased from equity prices, even as bonds and currency remained calm, and that comes on top of the US$ 3 trillion erased from China and Asian markets since January.The sharp sell-off of the past four weeks has many causes :

It started with the sharp sell-off in bonds that we had been expected all along,

it then gathered steam with the US – China Trade War where Donald trump aggressive posture created an unquantifiable risk for both the economy and corporate earnings,

and ultimately,  it accelerated with an uneven earnings reporting season, and disappointment coming from some of the best names in tech, the leaders of the entire 2009 -2018 bull market.

Liquidity

In our various posts since the beginning of the year, we had been warning about the turn of the liquidity cycle and its inevitable consequences ultimately on highly elevated equity markets.

Our call made in December 2017 that inflation would come back in a sustainable way has been vindicated almost everywhere, and US interest rates started rising significantly as a consequence.

Donald Trump’s bashing of the President of the FED, Jerome Powell, blaming him for the market meltdown, did not help.  Never in the history of the USA a President called a FED Chairman “loco”. Even Jimmy Carter praised Volcker in 1982 when he raised raised to 18 % killing all his chances of being re=elected.

The FED is independent by nature and in fact, one of the main problems of the past 40 years has been that the Central Bank did not pay enough attention to asset inflation and focused solely on goods and services prices to set monetary policies.

Excess money in an economy always feeds first in real estate and equity prices before showing up in the CPI and this narrow focus of the FED led to air least two periods of excesses of overvaluation that ultimately triggered recessions later on.

For once, the FED, despite being still in neutral territory, takes a serious look at Asset price inflation and Jerome Powell should be praised for that.

With eight rate hikes since 2015 already and more to come, it is clear that equity investors are starting to take notice.  Higher rates mean higher financial costs for corporations and less margins ultimately.

The most visible evidence that tighter conditions are at the center of the tempest is in rate-sensitive groups like homebuilders and banks.

Building companies have tumbled in nine of the past 10 weeks as higher borrowing costs contributed to disappointing housing data.

Banks, normally beneficiaries of higher rates, have slumped 15 percent on concern rising financing costs have crimped loans.

Signs of monetary stress are visible almost everywhere in US equities, from slumping bank stocks to the 33 percent plunge in home builders since January.

They are also showing in the market’s newfound willingness to differentiate between defensive and cyclical stocks, a bias absent from recent corrections meltdowns.

The sell-off that started in January 2018 shows that the markets are pricing in slower growth and less positive earnings in the future.

However, interest rates are nowhere close to a situation that would lead to a major crash or even a bear market at this stage.

With US interest rates at 2.25 % and inflation at 2.3 %, US Real interest rates are still marginally negative and liquidity is still plentiful.

At this stage of the cycle, a “normal” monetary policy would see interest rates at 3.5 %, the level of the nominal growth rate of the economy.

Equally, US bond yields finally spiked above 3 % in September, but have remained calm since with 10-year bond yields trading at barely 3.10 % and 30 year bonds at 3.30 %, discounting almost NO inflation in the long term.

The liquidity tightening has been extremely moderate so far, and if its has contributed to the recent sell-off, higher interest rates are neither the main culprit nor a serious cause of concern yet.

Moreover, recent data shows that the US economy’s long expansion is slowing. The American economy cooled a bit last quarter, a slackening in growth that was widely anticipated. The 3.5 percent increase in gross domestic product in the third quarter of 2018 was lower than the red-hot 4.2 percent of the preceding three months and the 4.1 % of the first quarter.

3.5 % is still a good number for the US economy, but it demonstrates that Donald Trump’s tax cuts effects won’t last beyond 2018 and that the US economy may revert towards it 2 % average in 2019.

Investors should therefore not be overly concerned by the FED raising rates too high too fast, and things are definitely not looking brighter in Europe which has slowed down in the last quarter and China where the economy is slowing down structurally.

Bond traders are now barely pricing in two rate hikes between year-end 2018 and year-end 2020, eurodollar futures data show. The Fed projections, released a month ago with stocks near records, call for twice as many over that period, meaning that US rates will barely reach 3.25 % by 2020.

Not really something to write home bout…

Corporate Earnings

Third-quarter S&P 500 earnings season had a good start overall, underpinned by strong results in US domestic markets but with some pockets of softness in global  multinationals.

While some companies have reported higher raw materials costs, overall cost trends have not been overly worrying, especially in the context of strong revenue growth of 7–8%.

US corporate Earnings are estimated to grow at 23–24% for the quarter and 21% for the full year and guidance has been relatively positive for now.

The real concern relates to the reception corporate earnings received this season. Companies that beat estimates did not rise while companies that missed their estimated fell sharply.

AMAZON Inc. was down 10 percent in pre-market trading
after giving a disappointing revenue forecast for the holiday
period, while GOOGLE was down 5.9 percent after saying
bigger payouts to distributors plus lower ad fees are putting a
damper on revenue growth.

NETFLIX fell almost 20 % since reporting its Q3 earnings and Facebook who should report next week has never recovered from its sharp fall in August 2018 following concerns about its privacy policies.

The leaders of the market have been severely punished and something has definitely broken down in the entire psychological complex supporting the bull market.

A clear interpretation is that the stock market is correctly anticipating weakness in earnings and in the economy going forward and indeed, the consensus expects only 4 % earnings growth for 2019.

In other words, corporate earnings have peaked for the cycle and it will be difficult to justify the current lofty valuations in the face of weak earnings growth and higher interest rates ahead.

There are also no indications that the economy may be heading for a significant recession yet. Therefore corporations should continue to do relatively well, even if at a slower pace.

US – China Trade War

The real cause of the sell-off is probably the SU China Trade war and Donald Trump’s aggressive and unnecessary posturing against China.

His calculation seems to be that Republican voters share his hatred of China, but nothing proves that this is the case and he may be in for a nasty surprise in the upcoming Nov 6 mid-term elections.

The imposing of Tariffs on products imported from China will have negligible effects of China’s economy but will ultimately translate in higher costs for American manufacturers sourcing their components in China and will somewhat close the Chinese market to some US corporations and products.

In effect, they have added to the market psychology an element of Unquantifiable Risk for US corporations that investors do not know how to price.

China’s attitude has been to play it out over time and wait for the mid-term elections to truly act on the matter.  In the mean time, they have been letting the Yuan hover juts below the psychological 7 level, sending a signal that it is happy to keep its currency artificially low, but not allowing it to go lower and cause a flight of capital.

They have also clearly enacted policies aimed at boosting economic growth and intervening in equity markets to prevent an un-necessary melt down.

All the above may sound strange to Western investors, but they are very familiar to anyone who has been investing in Japan and Asia in the 1980s when the Japanese economy was maturing and the authorities had to handle fund managers with little experience and a lack of institutional depth of the market.

China is still generating record-high trade and finial surpluses and Donald Trumps’ sanctions will do very little to change that.

Most US corporate CEOs have voiced their concerns and most economic experts have highlighted the fact that the only solution was a structural appreciation of the Chinese Yuan.

But Donald Trump’s refusal to meet with China is all about the elections, but voters have now identified the sell-off in equity markets with the US Trade war and they will probably express their unhappiness with the losses in their 401-Ks on November 6th.

As we highlighted in our post titled DONALD TRUMP’s POLITICAL SUICIDE, the President chose the wrong battle with the wrong enemy and has shot himself in the foot.

Once the elections are out of the way, it is likely that the US trade War will soften, sending equity markets flying, particularly in Asia.

It is our view that the longest bull market in US equities has already peaked on January 26th 2018

The sheer weight of US equities in the global equity indices is taking the indices with it and the chart below shows the complex top that was formed between January and October 2018.

However, we are now reaching extremely oversold conditions and US equities are now trading at a major support that should provide the base for a year-end rally.

 

Moreover, some markets, such as Chinese equities, are about to embark on a secular bull market while the US equity market enters its secular Bear Market.

The current power play and ill-conceived US trade War against China has isolated the USA internationally and accelerated Xi JingPing’s accession to the role of respected world leader.

In a historical visit of Japan’s Prime Minister Abe to China, China and Japan capped a restoration of ties with agreements on everything from currency swaps to ocean rescue last Friday.

Shinzo Abe became the first Japanese prime minister to pay an official visit to China in seven years, as Asia’s two largest economies sought to play down disagreements that have hindered relations for decades.

Asia will be the main engine of economic growth of the world in the coming decade and the getting together of the two most powerful economic nations of the region does not bode well for America’s clout in Asia.

They both reiterated support for free trade and called for the early conclusion of a regional trade pact with 16 Asia-Pacific nations that doesn’t include the U.S.

After Abe and Chinese Premier Li Keqiang commemorated the 40th anniversary of a peace and friendship treaty on Thursday, the two held formal talks on Friday and oversaw the signing of cooperation agreements between the two governments.

Abe then met and dined with President Xi Jinping, marking a new high point for a relationship he has long sought to mend.

At that meeting, Xi said the two countries are becoming
increasingly interdependent and that they should be partners
rather than threats to each other,

Abe was accompanied to China by foreign and trade ministers
and a 500-strong business delegation. The two sides signed 50
cooperation agreements, including reviving a 200 billion yuan
($29 billion) currency-swap deal.

The neighbors also agreed to discuss establishing a clearing bank for offshore yuan and cooperation between Japan’s Financial Services Agency and the China Securities Regulatory Commission.

All the above indicates clearly that Donald Trump’s America is losing ground significantly on the international scene.

The latest blunder being the announcement that America would pull-out unilaterally of the Nuclear Treaty that has kept the world at peace since 1987.

This decision will further isolate the US from the rest of the world and brings vey little benefits apart from re-starting an armament race in the Pacific that the vast majority of Americans do not want.

Once the Us stock market confirms its bear market in January or February 2019, Global investors will shift their exposure from the USA to China in droves, fueling the first significant secular bull market of China.

Equities

Currencies

We may be reaching an important turning point in the EUR / USD pair.

The US Dollar seems to have completed a wave 5 bull structure into its August top, which represents a multi-month cycle peak. As our readers know, we have been amongst the few analysts to predict the rally in the US dollar this year.

The US dollar held above 95.00 and closed the week at 96.36 but failed to challenge its August high at 97.00.

Conversely, it made a significant new high against the EUR last week challenging the 1.13 level but closed at 1.14

The internal momentum in the USD has been deteriorating for the past few weeks and many reversals were recorded in Asian emerging currencies. Asian/EM pairs.

Commodities

Oil has peaked ! for good !  Stay Short !

Bonds