The Calm Before the Earnings Storm
After a rocky 2018, stock markets have rallied and bonds steadied so far this year as a result of the Fed’s more dovish tone, optimism over a potential US-China trade agreement, and the “bed and breakfasting” effect- where a stock is sold at the end of the year to crystallise a tax loss in the US before being immediately rebought in the New Year. So far this year, market movements have been driven by sentiment and tax practicalities rather than data, with a number of key indicators beginning to suggest weaker global growth. Over the coming weeks, we expect markets to decline as the corporate earnings season begins in the US, with weaker global growth and the effects of the US-China trade conflict feeding into lower earnings expectations.
Key data appears to indicate weaker global growth
Following a series of positive data announcements referring to lagging data towards the end of 2018 (such as employment and corporate earnings), in recent weeks, key financial data appears to now be supporting our expectations of weaker global growth over the last quarter of 2018 going into 2019. Trade growth slowed in 2018 and key global activity indicators are lower. We expect that weaker data will continue to feed through into markets, alongside weaker corporate earnings expectations for 2019. Key recent data highlighting this weaker growth includes:
- Reductions in Global PMI: The latest global PMI surveys featured a 27-month low for manufacturing, with services PMI remaining broadly in the range seen over the last 2 years. Q4 average PMI was the lowest since the end of 2016, indicating lower global growth. In the Eurozone, service sector activity plunged in December, representing slower growth in Q4 than expected.
- Weaker Consumer Confidence: Consumer confidence has declined in recent months on a global scale. According to Ipsos’s Global Consumer Confidence Index, consumer confidence is now at its lowest point in 14 months.
- Treasury Yield Movements: The 10-2 year treasury spread is converging, with the spread currently at 14 bps. Inversion of the curve is considered to be a key recession indicator. At current levels, the yield curve is indicating a 21% probability of recession in 2019, however this remains well below the key threshold of 30%.
- US ISM non-manufacturing Decline: This week, the ISM non-manufacturing index fell 3.1 points to 57.6 in December. After beating consensus expectations in each of the prior four months, the figure missed expectations in December. Under the headline, new orders and business activity grew, while supplier deliveries and backlogs pointed to slower growth. The overall decline indicates a cooling of growth momentum in US economy in 2019.
Earnings Expectations
Earnings season unofficially kicks off next week in the US, allowing investors to gain an insight into the underlying health of US companies. This earnings season will be even more important than in previous years, as investors attempt to understand the effects of key market forces on the market in 2019. Corporate earnings growth is likely to decline following a particularly good year last year, with trade tensions and tighter financial conditions creating headwinds over 2019. With the moderation of global growth, earnings season serves as a catalyst for an expected decline in equity markets. Earnings guidance during this period will be crucial, as Apple (which is typically seen as a bellwether for tech stocks and the wider market) last week announced a cut to its sales forecasts largely as a result of US-China trade tensions. It is our view that a series of global companies are likely to announce similar negative revisions over the next month.
Equity strategists have been cutting earnings expectations for Q4 2018 on the back of lower global growth and economic headwinds, however estimates remain high. For the S&P 500, the EPS figure was reduced down from 16.4% to 11.4% at the start of Q4. So far for Q4, 72 S&P 500 companies have issued negative EPS guidance and 33 S&P 500 companies have issued positive EPS guidance. As companies start to report actual Q4 results and forward guidance, it will be interesting to monitor the negative guidance and earnings surprise splits in comparison to Q3. In Q3, 78% of S&P 500 companies reported positive EPS surprise and 61% reported positive sales surprise.
Over Q4, median S&P 500 EPS estimates dropped by 3.8%, representing the largest percentage decline during a quarter since Q3 2017. After a particularly strong first three quarters of over 25% growth, Q4 is expected to be the first quarter of sub 20% growth since Q4 2017. In contrast, analysts expect single digit earnings growth for first three quarters of 2019, putting the extent of the impact of moderating global growth on corporate earnings into context.
Table 1.1: Expectations for earnings and revenue growth:
| S&P 500 Earnings Growth Projection | S&P 500 Revenue Growth Projection | |
| Q4 2018 | 11.4% | 6.1% |
| Q1 2019 | 2.9% | 7.3% |
| Q2 2019 | 3.7% | 6.0% |
| Q3 2019 | 4.3% | 5.8% |
| Q4 2019 | 12.1% | 6.9% |
| CY 2019 | 7.4% | 6.0% |
| FactSet Data 04/01/2019 | ||
Is the expected pull back likely to result in recession?
In recent weeks, fears of a global slowdown and pullback in equity markets in the first half of 2019 have raised concerns that of a deeper slump which would result in a recession. Although we expect equity markets will come under pressure over the coming months, it remains unlikely that this will lead to recession, with above trend global growth and low inflation. There have been four bear markets without a recession since 1946, during which the S&P 500 index declined by an average of 21% over a period of 8 months. The current data suggests that this is a more likely situation, with equity weakness expected during the first half of 2019.
2015-16 comparisons
Compelling comparisons can be drawn between the current economic situation and the late 2015- early 2016 backdrop. At this point, a strong US dollar was choking the global economy, oil was in decline, the Fed was ending QE and markets were pricing in a series of rate hikes, combined with weak Chinese economic data. In Q1 2016, the S&P 500 index posted the worst ever start to a new calendar year. After Q1, the scene had changed, resulting in a single rate rise in 2016 in December. Oil bottomed out at around $30 a barrell and the Chinese central bank delivered stimulus to boost Chinese and global growth. Over the year, stocks rebounded and the S&P gained 9.5% over 2016.
In comparison, current economic conditions appear very similar, with a strong dollar, declining oil prices, tighter financial conditions and weaker Chinese growth. In contrast however, US-China trade tensions weren’t a consideration in 2016, and negotiations are likely to influence markets until an agreement is made. It is likely that any agreement will boost near-term sentiment, however over the long term, slowing of the US and Chinese economies will continue and the impact to earnings over the last quarter of 2018 is likely to provide detail on the extent of the slowdown.
Additionally, we are not expecting a significant recovery in equity markets over the year as a result of lower global growth and tighter monetary policy. The pullback in equity markets is likely to be followed by a recovery and adjustment to a lower growth environment. As was the case in 2016, the current market downturn looks unlikely to be followed by recession.
Overall
It is clear that weaker global growth is beginning to feed through into the economic data, supporting our current defensive positioning and indicating significant downside risk to equities in the near term. Over the coming weeks as earnings season begins, we expect to see a series of earnings expectation reversions and negative surprises as earnings become more pressured in a lower growth environment and companies feel the effects of US-China trade tensions. It is our view that this is likely to act as a catalyst for a drop back in markets in Q1 of 2019.
Parallels can be drawn between current economic conditions and those experienced in 2015-2016, however the conditions are not identical due to evidence of weaker global growth and key issues such as US-China trade tensions. For this reason, we are not expecting a recession following the drop back in equity markets, however we are also not expecting as significant recovery as seen in 2016.
Based on current market conditions, the portfolios are well positioned to protect capital and benefit from a drop back in equity markets, with high cash levels to take advantage of opportunities as they arise. Over recent weeks, investors appear to have been following suit and positioning more defensively, with money market funds (cash or near cash funds) receiving $165 billion in inflows in November and December, the highest two-month flow since 2008. This came following a $42 billion outflow from equity funds as investors moved from equities to cash. Given current levels of market volatility and evidence emerging of weaker economic growth which is yet to be priced into markets, we continue to be defensively positioned until the data improves.
For anyone who wants further data to substantiate the position please review the attached Global Economic News Document.
Model Portfolios & Indices
Over the last week we have seen most of the indices that we track increase, returning some gains from the sharp falls towards the end of 2018. Volatility remains high in equity markets, with market movements in the last week being predominantly driven by sentiment.
Following the defensive repositioning of portfolios in December, our OBI portfolios have a low equity allocation, with exposure predominantly coming from the FTSE 100 and S&P 500 shorts as well as the Odey Long/Short European fund. For this reason, the equity exposure within portfolios is inversely correlated to markets ahead of the expected decline in Q1 2019. The model portfolios are more non-equity heavy due to excessive downside risk in traditional long equity exposure, therefore performance is less correlated with index movements. We still hold a multi-asset mandate which allows us to capture some of the upside in equities, but the fund managers are able to become defensive when equity markets are eroding returns.
Important Information
The data above will not directly correlate to the indices as there is always a delay in pricing because the US markets close significantly later than the European markets and the Asian markets. The data set above reflects the last close and much of the days movements will not yet be reflected in the portfolios due to pricing delays. You cannot therefore directly correlate indices to the portfolios. The value of investments may fluctuate in price or value and you may get back less than the amount originally invested. Past performance is not a guarantee of future performance. Performance figures quoted include the fund manager charges but exclude other fees such as adviser, custodian, switch and/or discretionary investment management fees. Unless otherwise instructed and accrued, income is reinvested into the portfolio.
This Day in History
On this day in 2007, Apple CEO Steve Jobs unveils a mobile phone he dubs “revolutionary and magical,” and the touchscreen device becomes the first in a line of iPhones that will go on to sell hundreds of millions of units.
As always have a wonderful week and stay safe.
VBW
Jason
