Markets this Week: US-China Trade, FOMC Minutes, Bank Net Interest Margins

Alex Cho

Alex Cho

CEO l Research Director

[email protected]

Weekly Markets Review – 11/20/2019

Markets pulled back today, on reports of a stalled US-China deal pertaining to phase 1 negotiations. This is in-line with some of the commentary we’ve heard from the buyside on diminished expectations of a phased-in trade deal, where investors were unsettled by the conflicting reports of a trade deal from Chinese media outlets, and whether China will ink a deal before the end of 2019.

The S&P500 fell by -11.72 points and closed down on the session by -0.38%. The Dow Jones fell by -112.93 points and closed down on the session by -0.4%. Overall, the market sentiment is slightly weak in relation to the priced-in expectations of a phase-1 trade deal, but quickly recovered, as expectations of further progress on the US-China trade deal weren’t so elevated to begin with.

Reuters reported earlier today:

Just over five weeks later, a deal is still elusive, and negotiations may be getting more complicated, trade experts and people briefed on the talks told Reuters this week.  Asked Wednesday about the status of the China deal, Trump told reporters in Texas “I don’t think they’re stepping up to the level that I want.”

Nonetheless, Chinese media pundits now also say they are pessimistic about a deal. “Few Chinese believe that China and the US can reach a deal soon,” Hu Xijin, the editor of the state-backed Chinese tabloid Global Times, tweeted on Wednesday. Hu concluded his tweet: “China wants a deal but is prepared for the worst-case scenario, a prolonged trade war.”

While, the on-going particulars of the US-China trade deal leads to speculation of a 2020 delay, we believe markets have already priced-in some of the diminished expectations. It might be a while for agriculture stocks to experience relief, given the out-sized publicity tied to farmers, and the presumed relief a trade deal would have. Unfortunately, the sectors that have priced-in expectations of the phase-1 trade deal would be inclusive of agricultural equipment makers like Caterpillar (CAT), or Deere (DE). Other companies that were hopeful of China banking deregulation via the Phase-1 deal would be inclusive of banks like Citigroup (C) or Goldman Sachs (GS), for that matter.

The near-term headline risk does paint somewhat of a gloomier holiday season, albeit corporate earnings, and some relief in the form of FX, and heightened anticipation of Fed rate cut could diminish volatility as we exit November and head into December.

Should equity investors remain optimistic?

That being said, we continue to affirm our positive stance on equities, as business fundamentals will remain the key to sustaining a recovery in equity valuations. The vast majority (roughly 92%) of S&P 500 companies have reported quarterly earnings/sales for Q3’19. BofAML research suggests that the aggregate S&P 500 constituents reported a +2% Q3’19 dil. EPS beat with overall dil. EPS down by -1% y/y. The improvement in earnings came from healthcare, and technology sector stocks.

The analyst consensus now anticipates flat y/y Q4’19 dil. EPS growth across the S&P 500 Index, according to BofAML. This implies that expectations have softened heading into a Q4’19 earnings season where seasonality tends to represent a meaningful percentage mix of total annual sales, especially when pertaining to specialty retailers, and some e-commerce names as well.

Source: Trading View Dollar Index Chart

What could offset some of the weakness in y/y earnings and revenue comps could come in the form of FX (foreign exchange), which would have an aggregated impact based on q/q comps where the Dollar Index peaked at 99.50 in September, 2019 and has since declined from the start of October to $97.96 towards the end of November. This could help with earnings/revenue print-outs when companies report Q4’19 earnings in January of 2020 assuming the DXY continues to trend lower, albeit this would require some additional Dovish Fed policy in the form of an interest rate cut.

Federal Reserve more dovish heading into December?

The FOMC Minutes from the October 29-30 meeting were released today, on November 20th, 2019. The sentiment from the meeting suggested that the prior -25bps interest rate cut passed by a narrow margin with some of the Federal Reserve board participants on the fence.

Quoted from FOMC Minutes:

A couple of participants who were supportive of a rate cut at this meeting indicated that the decision to reduce the federal funds rate by 25 basis points was a close call relative to the option of leaving the federal funds rate unchanged at this meeting. Many participants judged that an additional modest easing at this meeting was appropriate in light of persistent weakness in global growth and elevated uncertainty regarding trade developments.

Based on the prior dot matrix, 7 votes were in favor of 1.5%, 5 votes were in favor of 1.75%, and 5 votes were in favor of 2.0%. So, the votes needed to push rates to 1.5% came from the fence-sitters at 1.75%, which implies that the recent rate cut passed by a very narrow margin, and while we remain optimistic of further easing by the Federal Reserve, it would be contingent on worsening macroeconomic trade headlines tied to US-China, which could provide some of the air cover necessary to justify an even more aggressive interest rate cut to close the year.

Otherwise, the markets are pricing-in expectations of another rate cut in 2020. Of course, we’re still in the midst of a corporate earnings recession, and absent of some signaling from the Federal Reserve, the FX drag alone could signal that the Federal Reserve’s policy stance isn’t keeping pace with rest of world Central Banks. However, there are a number of proponents that suggest that absent the hawkish stance by the Federal Reserve, the Fed would run out of policy levers in an adverse economic scenario.

Notwithstanding, media outlets have already published reports in-light of the FOMC meeting minutes suggesting that the Federal Reserve won’t cut interest rates absent of troubling economic data points in the interim. Also, the Federal Reserve’s justification for not raising interest rates ties into interim consumer sentiment surveys and core-CPI (inflation) metrics.

The referenced commentary from the FOMC minutes is cited below:

With regard to monetary policy beyond this meeting, most participants judged that the stance of policy, after a 25 basis point reduction at this meeting, would be well calibrated to support the outlook of moderate growth, a strong labor market, and inflation near the Committee’s symmetric 2 percent objective and likely would remain so as long as incoming information about the economy did not result in a material reassessment of the economic outlook.

While, we view the commentary exiting the October FOMC meeting somewhat troubling for sustaining the raging bull market. We also anticipate that the on-going headwinds tied to US-China, and the recent passage of legislation tied to Hong Kong will diminish trade sentiment even further, suggesting further phase-in of tariffs, which were delayed. Those sequence of events would trigger some cautionary economic data, albeit it would be driven by taxation, and worsening of corporate profits absent of trade-exclusions like the ones Apple were able to get via its Austin, TX production facility.

It’s also worth noting that the Fed doesn’t define its policy on a preset course, and any stiffening conditions tied to trade, or perhaps weakness in economic data tied to Q4’19 seasonality could force the Fed’s hands, albeit we’re not seeing much in the way of economic data that would cause the Federal Reserve to cut rates absent of some exogenic factors like worsening US-China trade relations, or market paranoia tied to a Trump impeachment. Corporate earnings have softened, however, and given the weak sentiment tied to CEO/CFO surveys tied to cash investments, we could see some negative impact in the form of weakening corporate investments, which could trickle into the U.S. economy, albeit that’s more of a FY’20 theme worth noting, as opposed to an immediate seasonal drag.

The Federal Reserve also cited similar risks in the FOMC minutes, “the risk that the weakness in domestic business spending, manufacturing, and exports could give rise to slower hiring and weigh on household spending remained prominent.” Therefore, the only telltale sign that could force the Fed to weigh further interest rate cuts is if corporate earnings continue to stagnate, thus resulting in weakness of domestic investments in the form of hiring, or capital expense.

Troubling data on big U.S. Banks?

Bank sector stocks escaped Q3’19 earnings season on the back of strong trading revenue, and some deposit growth. However, the impact from a lower interest rate environment suggests a number of factors that could put pressure on bank’s financials heading into FY’20. This is mainly because of lower interest rates, which compresses net interest margins, and while some banks could hedge some of the interest rate volatility, the impact from these slimmer net interest margins has everything to do with the low rates banks pay depositors in relation to the benchmark rate set by LIBOR, which is contingent on the Fed’s open market policy.

Hence, the LIBOR-2YR Treasury spread is extremely narrow, and it’s why we view the environment as being somewhat less hospitable for conventional banking, although the diminished interest rates sets-up a strong environment for Investment Banking, and deal underwriting tied to M&A’s, and also debt restructuring, and corporate bond underwriting, which picks-up in activity whenever interest rates drop.

As such, the mixed-environment heading into FY’20 suggests a number of cautionary signs, and also a springboard of opportunity contingent on the business-mix of a bank, and whether the bank has hedged for interest rate exposure. The questionable trade environment and slowing corporate earnings growth could diminish expectations on broad stock market gains in 2020, which has questionable implications on some of the major banks, which rely on market volatility to generate commissions. But, with interest rates trending lower, we anticipate that market volatility will decline, and as such trade commissions among the major exchange operators, and major broker-dealer desks will also slow.

In other words, we view the environment as being a mixed bag for banks next year, and while some banks will continue to outperform sector laggards, the sector as a whole will be more reliant on cost controls, and improvements in IB underwriting for bond and equity issuances, while trading revenues will also be relied upon, along with consumer/commercial loan growth to offset weakness in trading volume, and narrowing of net interest margins.

S&P Global Ratings released troubling remarks tied to the banking sector on Nov. 20th, 2019:

In the third quarter, industry earnings declined by about 7% year over year but were roughly flat when excluding some very large nonrecurring charges and net investment losses. We expect earnings at the largest banks will be relatively stable for the remainder of the year, assuming continued economic growth, and capital markets revenues will benefit from an easy year-over-year comparison with fourth-quarter 2018. More than four-in-five respondents to a polling question during the webcast said they believe bank earnings in 2020 will either be flat or down, while just 13% said they expect an increase.

Sentiment tied to bank earnings could improve contingent on financial outlook from Q4’19 earnings, albeit we’re not holding out breath for a miraculous growth year for financial sector stocks in 2020. Also, this doesn’t mean that there aren’t pockets of opportunities among bank sector stocks, or financial sector stocks. Though, we’d be more opportunistic when considering payment processors, as opposed to pure financials heading into 2020.

Final thoughts

On-going difficulties with inking an US-China trade deal has put pressure on equity markets in November, we anticipate that a trade deal won’t happen in 2019, and further delays were perhaps triggered by the recent legislation on Hong Kong, and on-going Trump impeachment hearings, which has remained a headline risk for securing a US-China trade deal. Also, absent of a US-China trade deal we anticipate some negative tailwinds from the imposed tariffs, which could force the Federal Reserve’s hand assuming equity markets price-in more risk and prevailing market sentiment weakens in a seasonally strong quarter.

When pertaining to the Federal Reserve, we’re still on the fence of the likelihood of a 4th interest rate cut in December. Given the FOMC minutes, there’s very little indication of a 4th rate cut, given the 3rd rate cut passed by a very narrow margin, and with no additional plots suggesting interest rate will reach 1.25% in 2019, among any of the FOMC member votes.

In 2020, we anticipate somewhat of a tougher environment for bank earnings given the lower interest rates, and policy path that suggests additional rate cuts are in store for 2020. Some of this is driven by the weakness in corporate earnings, and trade policy uncertainties. Given these factors, we anticipate weakness in net interest margins, which in turn puts more pressure on operating expense efficiency, and growth in revenue from other segments like trading, investment bank underwriting, and growth in total loans to offset lower interest margins.

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