Submitted by Peter Garnry of Saxo Bank
Summary: Equities continue to rally although the first week of December has been more choppy due to mixed trade headlines from the US and China. Overall, US equity valuations have hit dangerous levels for long-term investors and the recent Swedish Services PMI figures are highlighting emerging spillover effects from manufacturing into the services sector which is a dangerous dynamic as it goes against the current economic rebound narrative holding up equities.
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As regular readers of our views on equities know we have been defensive on equities for more than a year. The last two months we raised the concerns that equities are detaching from the realities of macro risks while acknowledging the momentum in equities. The broader narrative supporting equities is central bank easing, hopes of more fiscal impulse and lastly the “phase one” trade deal between the US and China.
This first week of December has seen yet another rollercoaster event on the trade talks from Trump signing the Hong Kong bill agitating the Chinese side, to both sides saying that trade talks are progressing before Trump the other day said “trade deal might wait until after 2020 election”, before both sides again yesterday said talks are advancing. The facts are that the US has a 15 December deadline on additional tariffs on Chinese goods, and given Trumps unpredictable nature and his recent action to slap tariffs on steel and aluminum on Argentina and Brazil, he could surprise the market by raising the tariffs on 15 December. In this event equities would hurt as liquidity is typically declining leading up the Christmas holiday period. But for now this week’s trade headlines have not really tested the market as shown by the spread between the VIX Index and the two-month futures contract.
Another concern that investors should take note of is equity valuations. S&P 500 is now seeing a valuation that is the highest since 2001 (excluding the Jan 2018 observation) highlighting stretched market conditions and lower implied expected returns. Based on the current valuation level in the S&P 500 we observe historically a 0.5% real return annualized with a +/- 2%-points uncertainty. This means that investors buying into current valuation levels are pursuing momentum effects rather than long-term return expectations. These moves never end good.
But the central question for investors should be whether yesterday’s weak Swedish PMI Services print for November at 47.9 is a sign of emerging spillover effects into the broader economy. If Sweden leads Europe and potentially the US due to its pro-cyclical characteristics then yesterday’s print is ugly reading for investors. Sweden’s economy is approaching activity levels not observed since the euro area crisis in 2012. If the spillover effects from the manufacturing recession are real and growing then the global economy will be hurt badly. Policy rates are already low providing little firepower for central banks so fiscal will have to take over to reverse the bleeding. But fiscal moves slower and is certainly behind the curve in many countries, most notably Europe, which means macro weakness in 2020 could be worse than most think today. Watch Sweden is our only message in this monthly equity update.
As we have argued many times recently negative rates have hit the end of the road. It’s clearly not strengthening the credit channels and the banking sector business model is not working on the current monetary policies. In our view, led by the Riksbank, ECB will begin next year to forward guide markets about lifting rates regardless of the macro outlook in order to soft pressure Europe’s government to do more and create a better “policy mix” using ECB president Lagarde’s own words.
When we look across the economic landscape it’s clear that the UK and Europe have the most room for maneuvering on the fiscal side with especially Europe running too tight budgets relative to the current trajectory of the global economy. But here lies also the upside potential for next year. European equity markets could be the big surprise next year if both the UK and EU loosens the purse string as it could drive stronger currency and ultimately demand. If the ECB in addition indicates a shift in its monetary policy then banks would significantly add to performance. Also note today’s decision by the Japanese government to launch a $121bn stimulus programme to revive growth. It’s already starting.
Semiconductors stocks have done very well despite challenging trade environment as demand has remained robust and some frontloading by China has likely taken place. We like to use South Korea and semiconductors as leading indicators on the economy. Numbers out of South Korea are still worsening and the trade uncertainty is holding back investments among many companies. The hesitation to do investments are beginning to feed through to the semiconductor industry with operating earnings showing the biggest drawdown since 2012. Semiconductor earnings doubled from late 2016 to late 2018 which has fueled strong sentiment. Our view is that a lot of the hype around AI will cool down significantly in 2020 and with it demand for semiconductors.