In a week when newsflow competed for airtime with post-mortems on the 10-year anniversary of the Lehman collapse, all risky markets have pushed higher: the S&P500 is near its late-August peak; some sectors like Consumer Discretionary and Healthcare have reached new all-time highs; and the EM complex has rallied from 2.5% (MSCI EM and EM Currencies) to 10bp (Sovereign and Corporate spreads).
The catalysts have been eclectic: mixed Chinese data; softer-than-expected US inflation readings; surprising interest rate hikes in Turkey and Russia; and reports that the US had invited China to resume trade negotiations at an unspecified date (which however may now be off). On the last issue of a possible US-China rapprochement, note that the run-up to a similar high-level meeting in late August triggered equivalent market rebounds. But after multiple false dawns, such headlines may start to yield diminishing returns.
In any case, as JPMorgan notes in its weekly cross-asset strategy note, with several markets reaching “extreme levels” (EM assets generally cheap, US Equities near all-time highs and oil near four-year highs) the bank evaluates five issues on which capital markets will reverse or extend this fall.
- US-China detente (low odds, high market impact);
- Firmer China activity data due to stimulus (high odds, moderate impact);
- Policy orthodoxy in large EMs (moderate odds and impact);
- An even tighter oil market (moderate odds, high impact);
- Weaker US earnings growth/narrower profit margins (low odds this year, high impact).
More details on each of these key market-determining catalysts.
1. On the Chinese detente, JPMorgan’s John Normand writes that he isn’t hopeful that gains will extend much over the next month, because some of the US’s demands (like a much lower Chinese trade surplus) look unachievable given basic economics, and others (like China ending industrial subsidies) are too existential for China to abandon quickly. Hence the likelihood for this conflict to persist for at least as long as Trump is President. Meanwhile, as the WSJ reported, Trump is set to enact another $200bn in Chinese tariffs as soon as Monday, while China may retaliate by crippling US supply chains.
Seen in this light, JPM says that the risk of a destabilizing, contagious move in the renminbi post-sanctions is a wildcard. As a result, the likelihood of near-term volatility and/or drawdown keeps JPM’s overall recommendations neutral through offsetting shorts in EM duration and benchmark exposure in EM FX and Credit. Here, the bank also notes that it has been been tracking President Trump’s approval rating as one possible constraint on his international aggression. But with the economy and the stock market booming, it’s unlikely that an inflection point in his alwayslow popularity will drive a policy turn soon.
2. Second, is the true reason behind China’s recent weakness, a secular slowdown in both the economy and credit: To JPM, the second key factor to watch for is an upturn in Chinese credit and investment data due to recent monetary and fiscal stimulus. This is because China’s investment cycle remains a key medium-term driver of numerous markets (mainly Base Metals and Metals & Mining, sometimes broader EM Equity and Bond indices) through commodity demand. However, as shown below, so far there has been no joy: August readings on China credit (total social finance) and fixed investment continue to show deceleration.
That said, JPM’s China economists expect stabilization in the next one to two months but no robust upturn, given how much more limited and narrow this year’s measures have been compared to those in 2012 and 2015. Stability in these indicators should be enough to put a floor under the renminbi, Base Metals, some commodity currencies, China Equities and EM Equities given their current risk premium and light positioning – assuming that the US is not imposing punitive tariffs simultaneously, which however in light of this weekend’s news is a very big assumption.
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3. At the country level, turning points can come when monetary policy is tightened and macro imbalances fall, thus reversing the vicious circle of currency weakness and equity contagion. Turkey’s surprise +625bp rate hike this week to 24% was a necessary condition towards lira stability since it put the country’s real policy rates in the +5-10% zone usually required to reduce severe imbalances, of which Turkey is an outlier.
The missing component is the medium-term fiscal program, particularly as it relates to supporting banks and corporates. Argentina is demonstrating commitment to very high rates since hiking nominal ones to 60% in late-August (or about 15% real, assuming 43% inflation this year). But it is early days here too, and the new IMF monetary program has yet to be released. Brazil’s almost-daily Presidential election polls remain inconclusive, which means it’s tough to assign decent odds for necessary fiscal consolidation next year. Indian policymakers are hinting at rate hikes but have moved slowly relative to market stress.
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4. Then there’s oil, because with so much EM stress, the other consequences of President Trump’s foreign policy – a Brent oil price that has returned to a four-year high of $80/bbl – is sometimes overlooked. As JPM points out, given the President’s initiatives, EM currencies and oil are the only two markets where implied volatility has trended higher this year.
The turning point indicator to monitor here is the global oil balance. Supply growth has been undershooting demand growth since early 2017, in turn reducing excess inventories, tightening balances and supporting prices.
Hence the JPM view was bullish until mid-year, then became neutral-to-bearish on demand risks from high prices and the June OPEC agreement to raise output and offset any reduction in Iranian crude exports due to US threats. Furthermore, the bank had expected a tightening balance to loosen into surplus by Q4 and push prices to the mid-$60s by year-end. Here the unknowns are ere how many countries would follow US demands, and how much spare capacity Saudi Arabia could deploy. Hence the bank’s recommendation mid-year to take only part profits on oil trades by closing longs in Brent futures and oil currencies but to stay overweight US Energy Equities and HY Energy Credit. With supply stresses still broad (Libya, Venezuela) into the Nov 4th deadline for US sanctions, oil markets have stayed tighter than the bank has expected, which means price risks are on the upside.
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5. Finally, for US Equities, which remain one of only three risky markets to outperform cash this year – along with US HY Credit and Oil as shown in the chart below…
… JPMorgan warns that an inflection point could come when earnings growth slows materially and profit margins compress. That said, the bank is doubtful either dynamic materializes in 2018 given how the impact of the US’s twin fiscal eases is spread over several quarters (tax cuts dominate this year and fiscal spending next year), and how gradually the Fed will move to restrictive monetary policy late next year. In fact, JPM’s strategists think Q3 earnings growth could come in at 24% year-on-year, so barely decelerating from Q2’s 25% pace. And even though US wage growth has accelerated to a cycle high, a near-concurrent rise in productivity has preserved margins.
Thus, the trackers for turns in US markets this fall are the more global ones discussed earlier than the organic ones revealed through earnings, which continue to support a strong picture for US stocks.