Weekend Markets Edition – 12/01/19
Markets tested new all-time highs this week before experiencing a modest pullback towards the Friday session. The Dow Jones started the Monday at 27,820 before peaking at $28,120 (new all-time highs), and then closed the week holding onto gains at $28,051.
Softness in trading on Friday is normal behavior where markets are bracing for momentum to the upside, and traders exit for profits before heading into the holiday weekend (probably to fund some shopping or vacation).
We anticipate momentum to continue into the end of 2019, given the diminished headline risk, reversion to positive economic sentiment, and priced-in risks of US-China trade. While, the markets have used this as justification for headline-based selling, we believe bulls have finally climbed the wall of worry given the reversion to a steepened interest rate curve, positive economic data, and priced-in expectations on corporate profits for 2019.
While, 2019 has been a bouncy year, we’re finally turning the chapter to the 2020s, which should give investors some relief, and excitement at the same time. We generally believe that this bull market phase is more protracted, and while higher prices lead to squeamish thoughts when hovering at higher price levels, we tend to be more optimistic given the diminished balance sheet risks of big banks, on-going corporate investments, and sustained low-interest policy. The new normal, where interest rates remain low, and investment activity is rewarded without the perceived risk of inflation creates a strong environment for equities. It’s also why various macro strategists voice bullishness despite voicing some concerns tied to higher valuations.
Benchmark treasury yield volatility subdued whereas equities are back in favor
Source: Morgan Stanley
2Y-Treasuries traded within a fraction of a basis percentage point, within a 1.608%-1.6% range (less than a sliver of .01%), implying very few opportunities to trade fixed income on volatility (even with leverage). Whereas, the 10-year, 30-year treasuries weekly trading range were 1.759%-1.777%, and 2.225%-2.24%. The volatility is mostly at the long-end of the curve, and so the real fixed income opportunity ties into 10-year, and 30-year treasuries assuming interest rates trend lower over the course of 2020, which is still a distinct possibility.
In other words, the bullishness in the global bond market will likely continue, as we have witnessed the continuance of the “new normal” when pertaining to zero lower bound, or even negative interest rate policy.
Interest rates are at the lowest rates in 5,000 years, and so while there’s a glut of money roaming the financial system, it has been particularly resistance to inflation. We anticipate that some of this is driven by technology and efficiencies in manufacturing paired with a transition towards a service-based economy where pricing on baskets of goods has trended lower, whereas service-based consumption has continued to trend higher. CPI metrics might not capture some of the inflation in pricing when pertaining to various service models, where the cost of something increases at a much higher rate than the reported inflation figure, as it isn’t captured in the pricing index of various government surveys.
When it pertains to central bank balance sheets, the return to negative yielding debt has been more pronounced over the course of 2019, with global volatility in equities exiting 2018 triggering the highest rate of open market operations across global central banks. We anticipate that the sudden inflection in the amount of negative yielding debt will continue to trend higher, as investors remain under-invested in higher-risk assets. The reliance on central bank balance sheets has tapered off a bit, but the long-term trend is quite obvious, central banks will continue to buy government debt in an effort to inject more cash into the system, and it’s why we’re on pace to grow to $18 Trillion in global central bank assets, which compares to the present level of $14 Trillion in total global central bank assets, as illustrated above by BofAML.
Interest rates will remain persistently low until we exit the “new normal”, albeit we’re not certain when we’ll return to a sustained boom cycle that’s well above central bank targets similar to the roaring 1920s, or the roaring 1950s, though we do anticipate that at some point within our lifetime we’ll witness the sensational growth that leads to the proverbial bust cycle of mega expansion cycles. Given the limited experiences of the millennial generation with rapid economic growth, as in this specific generation has never witnessed spiraling interest rates on high single digit GDP growth, so what feels like a strong expansion cycle is actually the normal trend line of growth dating back to the 1900s. It’s not that we’re growing quickly, but that we’ve been conditioned to believe that this is a booming economy, when in fact the data on a historical basis doesn’t exactly bear that out.
Therefore, we anticipate that the new normal is similar to the Greenspan Put era, and absent of exogenic risks in population demographics, or perhaps a death wave, there’s not a whole lot that can put the brakes on global economic output. Furthermore, while the sustained growth of the economy dating back to 2009 has been the longest-expansion phase we’ve witnessed in the United States in quite a while, it’s the protracted nature of the expansion that has made investors suspicious as opposed to the growth comps of the expansion versus various boom-bust cycles dating back to the 1800s, and with interest rates at the absolute low-point in human history dating back 5,000 years, it wouldn’t be surprising what we now consider to be a boom cycle wasn’t actually a boom cycle, but rather an era of growth that just barely outpaced stagflation.
Equities remain in focus, as fundamentals help justify return to risk-on behavior
Source: Goldman Sachs
Buying fixed income was the preferred set-up in 2019, given the decline in corporate profits/revenue growth over the course of 2019. However, as we exit 2019, we’re seeing a return to some corporate revenue growth, which is why we’re suggesting equities exposure heading into 2020 on heightened expectations tied to macro growth, and diminished FX headwinds in conjunction with recovery in sales growth comps given the weak 2018/2019 comps. As such, it wouldn’t be surprising if investors saw a resurgence in positive trading action similar to the 2012-2016 years where markets would persistently trend higher on diminished volume, and heightened investment. In other words, the trough in y/y sales growth is on a steady pace of recovery, as illustrated above.
Source: Goldman Sachs
When pertaining to valuation, the Europe and US are comparable on a PEG 12-month rolling basis, whereas Asia Ex-Japan equities are undervalued in comparison. Part of this is driven by differences in attitudes towards equities in Asian markets, where real estate trades at a premium, and equities trade at a discount, with more priced-in volatility in these assets given the various risk factors tied to Asian economies, and the differences in the pace of inflation-adjusted growth.
To price Asian equities comparably on a growth/comp basis, baskets like the Shanghai Composite, KOSPI, Hang Seng Index, India SENSEX would be trading at levels that are 50% higher, but instead, when pertaining to APAC economies the price of residential real estate tends to be much higher, especially in Tier-1 cities where pricing is far above the median home price in developed markets like the United States and Europe. So, the divergence in attitudes towards equities, and the persistence in asset flows towards real estate tends to be a mitigating factor, and also, the differences in monetary policy tends to suppress capital flows as there are numerous Asian economies with interest rates well above 3%-5% as benchmark interest rates, which is why there’s less cash chasing after paper assets in Asia currently, with the bulk of financial leverage deployed on ambitious industrial, infrastructure, real estate projects.
U.S. Retail sales likely strong on seasonality
Sales volume is anticipated to be more elevated on Black Friday, as consumer sentiment has returned in full force, which should help retail sector stocks, which have struggled for the past decade. That being said, the number of bargain opportunities are more concentrated in online retailers with more selection as illustrated above. Amazon (AMZN) and eBay (EBAY) tend to be more price competitive on electronics, toys, home a kitchen, and other items. Wal-Mart (WMT) trailed all the other competing retailers in the survey and was not a price category leader in any of the basket items referenced above. Whereas online marketplace eBay had the highest election of items, and edged out Amazon in terms of price discount, which isn’t surprising given the price competitive nature of the online retail platform.
According to eMarketer research:
UPS is anticipating a surge of returns this holiday season, leading into the new year. According to the company, 1.6 million packages are expected to be returned daily the week of December 16 leading into Christmas. And a record-breaking 1.9 million returns are expected to take place on this year’s peak returns day—January 2—up 26% over last year.
The increase in return activity is driven by higher gross merchandise volumes on online platforms, and more generous return policies for consumers. The increase in gift returns may diminish some of the improvement in same store sales volumes, or retail margins in Q4’19, which is worth noting. However, we tend to favor the e-commerce names notwithstanding some positive data readouts on brick-and-mortar retailers.
Who wants Donald Trump to get re-elected?
The irony is, regardless of how controversial this presidency has been for U.S. politics, investors aren’t too eager to jump on a Democratic presidential cycle quite yet. There’s not enough in the way of economic stimulus that’s being proposed in the Democratic Debates that gives investors much in the way of reassurance, much less the continuance of higher taxation as a policy lever to rebalance wealth distribution is out of favor among equity investors currently. While, there’s plenty of support for higher taxation, and even Medicare for All, which would end private insurance plans offered by companies among Democratic loyalists, the rest of the United States doesn’t actually feel that way, currently, and it’s unlikely that attitudes towards taxation increases will improve by the 2020 presidential election.
Sure, we’re in a battle of haves versus have nots, but those who want to maintain the status quo in terms of economic policy continue to outnumber the skeptics that question the pace of economic growth. While, Donald Trump’s policy stance on US-Trade relations with various foreign governments has been the major sticking point that Democratic candidates can rally around, there’s been no noteworthy candidate that has put forth broad sweeping trade reforms on the table that sounds believable, much less actionable.
Source: Morgan Stanley
Based on a survey conducted by Morgan Stanley, 54% of survey respondents anticipate their outlook to change based on who wins the presidency. More specifically, 78% of survey respondents anticipate markets to decline in the event of a Democratic presidency, whereas 49% of responses anticipate a rally if Trump were to get re-elected.
It’s not surprising, as Trump’s main political party platform revolves around lower taxation, stronger stance on trade, dovish monetary policy, deregulation, and fiscal conservatism. This isn’t a popular view among Democrats who prefer wealth distribution, but among those who want to protect their portfolio returns, it’s likely that they’ll lean-in on Donald Trump another time.
Source: Goldman Sachs
When it pertains to expectations, the repeal of the Tax Act would have a real downward effect on S&P 500 EPS, or if the tax cuts from 2018 were reversed, the impact would translate to a reversion of EPS metrics of $183 to $162 in 2021, representing a 11.4% decline in Dil. EPS, and would ripple into public equity markets via price/multiple compression, likely triggering a swoon in equity valuations by anywhere from 20%-30%. This could also lead to an even more difficult earnings recession than what was experienced in 2019. As such, we’re not convinced by any of the economic proposal put forth by Democrats, mainly because of the reckless political pandering that would not result in positive equity values, much less economic growth.
To be fair, Democrats aren’t the political party of preference if you want a booming economy, or pro-economic growth policy. However, when it pertains to various social issues, and the need for better income distribution, and wealth distribution that’s more equitable it’s the party for the common man, or women. However, when it pertains to what investors would want as an ideal scenario, the Democratic Party has yet to put forth something that would appeal to retirement minded investors, or those who have real value at stake.
Furthermore, the decline in popularity in Elizabeth Warren’s polling likely stems from the unwillingness of investors to rally around a 2% wealth tax, mainly because equities are volatile, and taxing capital gains before the gains are even realized is a big no-no, because they don’t know when the price of the stock will drop. Investors can’t afford the loss of capital appreciation on an on-going basis, especially if the wealth isn’t liquid, or ties into private ownership of businesses. Also, equity investors are accustomed to favorable capital gains tax rates, and taxation on the basis of realized capital gains, which is why the concept of a wealth tax on unrealized gains is broadly unpopular.
It’s not the type of redistribution event that would encourage investment given the penalty of holding onto liquid assets, and requirement to continually divest those assets regardless of price volatility assuming there is an unrealized gain. Not to mention, if wealth is taxed at 2%, what about the treasury bonds that yield just barely 2%? All of those assets would turn negative-yielding, and unless there was significant inflation, bonds would persistently yield a negative rate, which is why this form of taxation isn’t just reckless, it’s just not going to get Elizabeth Warren elected. It’s worth noting that this would only apply to the richest percentile of American households, but the richest percentile of American households won’t just roll-over, and accept a negative bond yield on their portfolios, and in cases where wealth is not liquid, they wouldn’t be able to pay those taxes either. It’s not a viable policy path, for those who sit at the top, and those who sit at the bottom. Obviously, something needs to be done about wealth inequality, but we’re not certain if the ideas put forth have enough merit, especially at the present juncture in time.
We remain optimistic on equities heading into 2020, and while investors are concerned when pertaining to politics, it’s worth noting the bigger picture, and the sustained path of economic growth. Markets might be volatile, but that’s a given in any year. Absent some exogenic risk factors, such as higher taxation, death wave, or some other unknown black swan event… we’re maintaining our positive stance on equities.
The opportunity in longer-duration bonds is more limited now that interest rates have already trended lower. It’s worth having meaningful fixed income exposure to maintain a hedge against volatility but given the priced-in impact from various negative headwinds, and the favorable growth comp set-up, we’d be overweight equities heading into 2020 whether Donald Trump does or doesn’t get re-elected. In other words, it’s not worth selling equities just because of a Democratic Presidency (if in the event it were to happen), but just keep in mind, that investors will panic if Donald doesn’t get a second term.
Disclosure: Cho Research was not compensated to publish “Weekend Markets Edition: Equities Back in Favor, Holiday Seasonality, Interest Rates at 5,000 Years Low, and Investors will Panic if Donald Trump Doesn’t Win Re-Election.” Though Cho Research does use the research dollars it
generates from other clients of our research service to fund market research
reports such as this. This document is not produced in conjunction with a
security offering and is not an offering to purchase securities. This report
does not consider individual circumstances and does not take into consideration
individual investor preferences. Recipients of this report should consult
professionals around their personal situation, including taxation. Statements
within this report may constitute forward-looking statements, these statements
involve many risk factors and general uncertainties around the business,
industry, and macroeconomic environment. Investors need to be aware of the high
degree of risk in micro capitalization equities, cryptocurrencies, crypto assets.
Independent equity research isn’t regulated by the SECand operates separately from more conventional sell-side equity research. Thepublication of independent equity research is unregulated and rules pertainingto published independent equity research are covered under “freedom of thepress” with legal case precedent taken all the way to theN.Y. Supreme Court to guard against libel based claims or claims of lossrelating to the publication of a report on a company. Any copyright claimrelating to infringement is covered under fair use of copyrighted materials. Sincethe use of material was derived into a separate form of analysis without anysubstantial content derived from any third-party no copyright claim can bepursued under common law. To discuss investment risk or to consider the riskspertaining to any securities it is recommended to consult a registeredfinancial advisor. To understand independent research it’s encouraged to readthis published article on independent equityresearch to become more familiar with industry standard practices and therelative value of independent equity research versus brokerage research andnews media.Cho Research, its subsidiaries, and employees may open along/short equity position at future date from the data of publication of thereport. The price per share and trading volume of subject company and companiesreferenced in this report may fluctuate and Cho Research is not liable forthese inherent market fluctuations. The past performance of this investment isnot indicative of the future performance, no returns are guaranteed, and a lossof capital may occur. Certain transactions, such as those involving futures,options, and other derivatives, can result in substantial risk and are notsuitable for all investors.