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Author: NN Investment Partners
Confusing signals are doing little to restore investor confidence, which has been shaky since the sudden sell-off on equity and bond markets in early February.
This year is shaping up as a different sort from last year. Following a 2017 that full of positive surprises in data, earnings, politics and policy, investors now face a less supportive and more uncertain environment and are less willing to take large directional bets. Nervousness has increased In the past three months, as reflected in higher volatility and sideways market movements. Year to date, global equities have gained less than a percent in euro terms, compared with a 4.9% increase in the year-earlier period.
Equity markets sends confusing signals
The equity market is currently giving confusing signals. Investors seem torn between strong earnings reports, higher interest rates, bottoming macro surprises, and a mixed set of political developments, which are certainly positive on the Korean Peninsula but more uncertain as far as trade policy is concerned.
The US earnings season is developing very well. About 81% of the S&P500 universe have reported first-quarter results, and of these, 79% did better than expected. The average earnings surprise is 7% and the average sales surprise is 1.4%. Absolute growth numbers are also good. Earnings growth amounts to 28% and sales growth is 8.5%, making this the strongest quarterly earnings season since 2010. As expected, the highest growth is reported in energy, where earnings rose 83%, driven by the big jump in the oil price.
It is also noteworthy that growth is driven more by improvement in operating margins than by tax reform (the average tax rate thus far has fallen by 5% from 25% to 20%). Earnings guidance remains solid with more than twice as many companies guiding consensus higher than lower, the best ratio since 2010.
But the market response to these strong results has been lukewarm. Nervous investors seem focused on signals that a cyclical top in earnings is near. Companies that hinted at a peaking earnings cycle, rising raw materials costs or higher labour costs were punished even if their results beat expectations. At the same time, there has been a recent stabilisation in global earnings momentum, which could lay the foundation for stronger markets. For the US, the full-year earnings growth estimate rose 1.3% in two weeks to 22%.
Investor nervousness evident in new sector leadership
Another recent phenomenon is the change in market leadership. Since the start of the earnings season, financials and tech stocks have underperformed the broader market, despite their strong results. The best performing sectors were defensives like utilities, telecom and real estate. The performance of these sectors, especially utilities and real estate, is counterintuitive in the light of the increase in bond yields we have witnessed over the past few weeks. It looks as if investors are also already looking for the top in the interest rate cycle. This seems at odds with the expectations of the Fed and most market watchers, including ourselves, of another six rate hikes by the Fed between now and the end of 2019.
A possible explanation lies in the positioning data for the sectors in question. Technology and financials are the two most overweight sectors in portfolios whereas utilities, telecom and real estate are underrepresented. This squaring of active positions looks consistent with the macro uncertainty investors are facing. We have made similar moves in the past months by cutting our overweights in technology and financials and by upgrading consumer staples. Another factor that may be at work is relative valuation. The ratio of cyclical versus defensive sectors on a price-to-book basis is currently at the highest level in over 20 years, a period that includes the internet bubble.
Trade tensions may pose threat to benign environment
We see no reason to implement a defensive overweight, however. Economic data levels are still strong and financial conditions are easy. Consumer confidence has reached levels not seen in the past decade. Generally speaking, there exists a positive feedback loop between consumers and corporates, creating an environment that is usually beneficial for cyclical sectors. However, risks to this environment have increased due to growing trade tensions. Politicians will probably continue to make threats and bold statements, which may weigh on investor sentiment. Trade wars can cause slower growth, lower profits and higher inflation, all of which are bad for equities.
Support for oil remains in place despite high positioning
High speculative positioning in oil represents a short-term risk for the oil price, but higher demand thanks to the growth recovery, a high degree of compliance to production cuts among OPEC members and other producing nations, and geopolitical risk could all underpin the oil price. The possibility of new US sanctions against Iran may justify a bigger geopolitical risk premium for the asset class. The energy sector is profitable and dividends look secure – worth noting, given the high dividend yield, now over 5% for European energy companies.
Signs of renewed USD correlation with Treasury yields
Another noteworthy recent development is signs of the return of a correlation between US Treasuries and the US dollar. Since late 2017, a steady increase in 10-year Treasury yields has been accompanied by a broad-based weakening of the dollar. Various reasons were given as to why this previously positive relationship had broken down, including the profligate spending of the US administration and the subsequent increase in deficits. Whatever the reason, we now see a return to the dynamic of a rising USD alongside increases in US.
US Dollar, Treasury yields again rising in tandem
One consequence of the USD’s weakness has been the build-up of significant short positions, particularly against the euro. Now that the USD seems to have re-coupled to US yields, and US yields are once again flirting with the 3% level, this extended positioning could now start to unwind and led to a broad-based strengthening of the USD. This would of course have an impact on asset class returns, with commodities generally weaker in periods of USD strength, while at the deeper level a combination of rising US yields and a stronger USD is a potential negative for emerging market assets.
