Multiple Contraction versus Earnings Strength
(This is part two of the weekend blotter, please find thefirst part here)
Earnings will have to do all the work
What I mean by all of this, is that with the Federal Reserve telling us last week that they will likely take cash rates above neutral, then the pressure on US multiples is going to continue. Therefore, for the US equity markets to rise, earnings will have to do all the heavy lifting. While buybacks have, and will continue to help, with long duration interest rates moving into a new paradigm last week, it will be the outlook for both current and forward earnings that will determine where stocks not only finish 2018 but 2019 as well.
The next month will be an intriguing time for markets. We face three broad questions:
How high will yields go in the next four weeks after a clear technical breakout at the back end of the US interest rate curve? The higher they go, they greater the pressure on multiples.
How strong will Q3 earnings be and what is the guidance going forward? This is the potential offset to a rising cost of capital. We know Q3 profits will be robust, but the key will be the future. Q4 should be strong but next year faces tremendous base effect hurdles. Strong profits, above expectations could still lead to higher prices even with multiple contraction.
Can Geo-political risks be avoided?
a. The US mid-term elections and how violently the US electorate rejects the policies of Mr. Trump. If it was just about economics, this would not be a problem for markets but there are social issues at play that frankly, are next to impossible to assess. A Democrat Sweep (unlikely) would be an enormous headwind to US stocks and therefore global beta. Mr. Trump’s policies are good for markets. How can the prospect of a reversal not create an issue?
If you are in London on Monday October 8th, come to the Royal Institution in Mayfair for my discussion on the US mid-terms with Brian Klaas, 5.30pm – 7.00pm
b. Italy: This piece has focused on the negative impact of a rising cost of capital. The widening of Italian spreads due to budget concerns will morph to not only the rest of Europe but to the emerging world as well. An Italian downgrade would be a beta event for all global assets.
c. Brexit: As we get closer to decision day, it appears to be becoming binary. A No-Deal Brexit would be USD positive and a stress on Europe and EM.
With all that is going on in the world, only a strong earnings season can compensate for a rising cost of capital that seem inevitable after the events of last week.
They are even more important given that we appear to be in an environment where “good news on the economy will be bad for the bond market” and hence all risk assets. Strong earnings will be the only driver of higher equity prices. Until we see these number in a week or so, higher yields will lead to low stock prices and a strong USD.
There is no such salvation for Europe or Emerging Markets. How can global growth improve and with it, the prospect of better profits for developed (ex US) and emerging economies alike, in an environment where the Fed seems determined the take cash rates above neutral? Without a rebound in activity, how do profits improve to such an extent that equities as an asset class can move sustainably higher? I am making an assumption that it will be really difficult for multiples to expand in an environment where the cost of capital in the US is rising and the outlook for the developed world is for rates to be flat to up. Without stronger growth, the prospect for international equity returns will be no greater than profit growth and if global GDP is likely to slow, the incentive to own stocks must fall.
As we go to print, the first round of the Brazilian election will be underway, with the pro-business / anti-decency far right candidate Jair Bolsonaro holding a 14-point lead over the PT’s Fernando Haddad, with these two most likely to meet in a run of at the end of the month. While a head to head race between the establishment candidate from the Worker’s Party (PT) and Mr. Bolsonaro will prove much closer, it is clear from the recent strength in Brazilian assets that the market has a candidate they can get behind. The next 3% of the BRL will be determined by his showing later today. Yet again, this prove that markets do not have a moral conscience.
US CPI is the most important data release for the week for obvious reasons.
Also, as I write this, China has announced a cut in the Reserve Requirement Ratio, effective Oct 15th. This is the fourth cut this year and history tells us that the market responses are generally muted.
On Monday, German Industrial Production and Singaporean GDP, Japan Current Account on Tuesday, on Wednesday UK Industrial and Manufacturing Production, and Japan Core Machine Orders, on Thursday Japanese PPI and US CPI, on Friday German and Indian CPI, Indian Industrial Production and US Sentiment by Michigan University.