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Investors in thrall of the market tug of war

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Market Forces is back after a nice break, and yes, the snow in Vermont was pretty good for some early season runs. Junior managed to nail “Exterminator” at Sugarbush and after a long absence I was once more reminded why this mountain is such a jewel of northern Vermont.

Now back to matters more pressing, namely the challenging double black terrain facing financial markets. Investing is an emotional business and we have begun 2019 at a point when Benjamin Graham’s description of the investor’s customary lot — switching between moments of panic, euphoria and apathy —truly resonates.

And what we are seeing is a tough, no-holds-barred tug of war. Are equity prices now cheap enough to warrant buying the dip? Or is the gloomy government bond market on the money, with its message of a slowing economy and a less robust pace of corporate earnings growth in 2019?

This is a big moment for risk assets after sentiment at the end of last week received a nice one-two uplift via a robust US jobs report and some soothing words of patience from Fed chair Jay Powell.

That good mood flowed into Asia on Monday as US and Chinese officials met in Beijing for a new round of trade talks, while Wall Street was solid after its big rally on Friday. Leading US equities higher on Monday were small-caps, an important barometer for risk sentiment.

Thanks to a US Treasury 10-year yield back down near 2.70 per cent and a big drop in the forward price/earnings ratio for the S&P 500 since September, the valuation case looks pretty good here for equities and credit. If you think early 2019 rhymes with 2016 — a popular refrain in some parts (see Quick Hits below) — then it is time to get back into the water.

More broadly, risk assets reveal that equity valuations are back in line with post-crisis averages, as gauged by earnings yields. This from BlackRock:

The trouble is, markets still have a lot to think over and the challenges remain formidable. We still have the unknown outcome of Sino-US trade sparring, China’s clearly slowing economy — which has knocked Japan, Europe and much of the emerging market sector — while threats over Brexit and Italy loom large for the eurozone.

Also playing a key role is the difficult-to-assess role of leverage that infuses portfolios built on the assumption of the easy money era staying in place. Much of the recent turmoil in markets reflects the withdrawal of central bank support. Prospective buyers of risk assets need to see an abeyance in the search for portfolio insurance — in the form of demand for money market funds, equity put options, gold, government bonds, the yen and Swiss franc — before they can conclude that any bounce will last.

Lena Komileva of G+ Economics makes the point:

“The only way that an over-levered market can self-adjust to a post-QE, post-GFC regulation environment of fleeting market liquidity is via wholesale portfolio de-risking and the build-up of hedging positions that embrace volatility in equity and credit portfolios.”

The looming hurdle now is that of the upcoming earnings season, already marked by Apple and Delta Air Lines guiding expectations lower. What really sticks out from that December jobs report is average hourly earnings growing at an annual pace of 3.2 per cent, the fastest pace in a decade, telling us that margin compression looms as a key market story.

Here’s Nicholas Colas at DataTrek on the dilemma facing equity investors as the results season approaches:

“Companies must convince investors that 2019 will show further earnings growth even as profit margins actually decline. Typical top-of-cycle stuff, in other words . . . And that’s never easy.”

Indeed, as DataTrek notes, analysts expect 7.3 per cent revenue growth in Q1 2019, but just 2.9 per cent earnings growth. For Q2, the call is 6 per cent revenue growth and 3.7 per cent earnings growth.

As an aside, a good friend of mine in New York who runs three bars/restaurants in the city is not a happy camper. He is seeing fewer customers and higher payrolls, as the minimum wage for 2019 was pushed up to $15 an hour for businesses with more than 11 employees. Anecdotal, maybe, but one small case of the margin compression wave coming.

At least the bar has been lowered for beating earnings estimates, as we can see here from the Institute of International Finance. 


So we have good reasons for a bounce, but whether 2019 rhymes with 2016 remains uncertain.

Oliver Jones at Capital Economics concedes there are similarities but here’s the problem: 

“With the world’s two largest economies leading a slowdown in global growth, we suspect that the recent bounce in stock markets will fizzle out, with most around the world ending the year lower. We doubt that optimism about the US-China trade talks underway today will continue to drive them higher in the meantime, either.”

Quick Hits — What’s on the market radar

Credit bulls look fondly back at 2016 — The credit team at Bank of America is in a punchy mood, noting that recent US data “is trying to fool markets into pricing an impending recession — just like in early 2016”. The recent widening in risk premiums has compelled the team to shift its stance on high grade to overweight from underweight, and they “continue to be bullish on credit fundamentals for 2019 driven by BBBs”.

Equity exchange wars — Trading equities in the US is already incredibly fragmented with some 50 venues in operation. Now, as Philip Stafford from FT Trading Room writes, a bunch of big players including Fidelity Investments, TD Ameritrade, Morgan Stanley and Citadel Securities plan to roll out the Members Exchange, or MEMX. It’s just the latest challenger to NYSE, Nasdaq and the CBOE.

Those with long memories will no doubt recall how investors and banks backed the creation of Bats and Direct Edge (now part of the CBOE) to take on the big exchanges. The catalyst for yet another exchange, which in a real throwback to the past will be mutually owned by its members, is the fight over data fees. NYSE, Nasdaq and the CBOE have a river of gold in fees and MEMX represents a significant escalation of hostilities.

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I’d love to hear from you. You can email me on michael.mackenzie@ft.com and follow me on Twitter at @michaellachlan.

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