Fourth positive month in a row for global equities

Supported by slightly improved economic data and better than expected earnings reporting season global equities gained for the fourth straight month. All major equity markets finished April in positive territory, while the US stocks showed the strongest performance with close to 4% gain and a new all-time high. Emerging market equities, led by the rise in Central and Eastern European stocks also reached a record level. This has pushed the global All Country World index to a new all-time high and a year-to-date gain of 17.5%. Latin American equities were once again lagging with a mere 0.3% increase for the month.

Equity Market Performance

  1m YTD 2019 Distance from all-time high
Developed Markets ex US (EUR) 2,6% 14,0% 6,4%
All Country World Index (EUR) 3,4% 17,5% 0,0%
Europe (EUR) 3,2% 15,6% 6,2%
Emerging Markets (EUR) 2,2% 14,0% 4,4%
S&P 500 (USD) 3,9% 17,5% 0,0%

* - based on monthly data
Sources: MSCI, finance.yahoo.com

Trade war escalated again

Global equities continued growing in the beginning May, making it to 97 trading days in a row without a 3% correction.  This was the second longest such streak in the current bull market.

Everything changed, however, in the second week of March, when Trump threatened raising the tariffs to 25% on 200 billion USD of imports from China, right before the Chinese delegation arriving to US for trade deal negotiations.  This threat has sent global equity markets lower, confirming that investors were betting on the positive outcome of trade negotiations.

As later came clear from media reports, the US negotiators got annoyed by China revising several previously agreed parts of the deal and Trump’s threat was used to pressure Chinese delegation. However, this resulted in negotiations ending without any deal. And although the parties agreed to continue talks, no specific timeline was set for the next meeting. Consequently, the tariffs on 200 billion USD of US imports from Chine rose to 25%, while China retaliated by imposing new tariffs on 60 billion USD of US exports to China starting from June 1st.

Moreover, Trump threatened to introduce tariffs on the remaining about 300 billion USD worth of imports from China. Such move by the US will not only cause additional retaliation by China, but will also make further negotiations harder. As the US is insisting on changing Chinese laws to implement clauses of the trade deal, the Chinese side will be resistant to make such concessions not to give impression that China can by threatened and bullied into concessions.

As a result, there is a clear possibility that no deal will be achieved before the second half of the year. Chinese side may think that Trump is more pressured on the timing because of the upcoming elections next year. While Trump believes that the economic impact on China will be much more significant, making it willing to conclude the deal faster.

Economic impact of tariffs on both countries will be fairly significant and Trump administration may be underestimating the effects on the US economy. First, China’s retaliation increases the cost of US exports, reducing the sales and resulting in the job losses in exporting industries. Second, tariffs on imports raise the prices of goods, reducing consumer purchasing power and increasing inflation. Such developments may cause a spike in inflation, leading to higher interest rates in a slowing economy. The Tax Foundation latest estimates show that all the currently introduced and threatened tariffs will reduce the US long run GDP by 0.75%, will reduce wages and will eliminate more than half a million jobs.

Global economic policy uncertainty index


Source: policyuncertainty.com

Although the economic effects will take time to realise, lack of progress and uncertainty may hit investor sentiment. This can result in more volatile financial markets as investors may overreact to any new information on the trade war issue.

Despite slight improvement global economic indicators still point to a slowdown

Global investors were positively surprised by the slight improvement of the forward-looking economic indicators for China. The Purchasing Managers’ Index (PMI) for both services and manufacturing sector grew compared to last quarter. More significantly, manufacturing PMI returned above 50, a level indicating future economic growth.

Summary economic indicator

  Value 1 month change 1 year change
Global Manufacturing PMI 50,3 -0,1 -3,0
Global Services PMI 52,7 -0,9 -1,1
Global Composite PMI 52,1 -0,6 -1,7
OECD Composite Leading Indicator 99,3 0 -1,0

Source: Bloomberg, OECD.org

As a result, investors believed that these economic green shoots will spread globally leading to a rebound in global economic growth. However, it looks like it will take more time for the positive effects to spread and global economic leading indicators continue to point to a slowdown in economic growth. At the same time, the US economy is showing continued strength with better than expected jobs growth in April and unemployment rate at a 50 year low.

Global inflation expectations remain contained. Therefore both the ECB and Fed signalled no changes to the monetary policy. The markets are pricing about 75% probability of a rate cut by the Fed until the end of this year.

No interest rate changes are expected from the ECB in the near term.

Earnings reporting season is turning out better than expected

The current earnings season is turning out better than expected, easing investors’ fears of a drop in earnings. In the US over 75% of companies reported better than expected earnings, which is significantly exceeding the long term average of 65%. Overall, US corporate earnings are expected to grow 1.3% compared to Q1 2018.

In Europe, despite expected 2.7% decline in earnings compared to last year, still more than 50% of companies report earnings that exceed analysts’ expectations. Globally 58.3% of companies provided positive earnings surprises. Moreover, analysts make positive expected earnings revisions for over 60% of companies.

Consequently, at the current earnings yield (earnings per share divided by price) global equities still provide a decent risk premium over bonds. Even for the US equities, which are the most expensive, the risk premium of around 3.4% is above the average since 2002 (3.2%). Historical data has shown that the higher the starting risk premium, the more outperformance stocks have tended to provide over bonds in the long term. Historically, with the risk premium around the current levels, US equities outperformed bonds by a total of around 36% over 5 years compared to average outperformance of 16% during the same period (based on the S&P 500 and US 10 year Treasury). In the shorter timeframe of one year, current level of risk premium has historically showed almost no advantage of equities over bonds.

Stock outperformance over bonds at different starting risk premium levels

Y – S&P 500 3-year return minus 10-year US Treasuries 3-year return, X – Equity Risk Premium

Sources: Bloomberg, finance.yahoo.com

Additionally, most analyst are expecting global earnings growth to rebound significantly by the end of this year. However, if global economic slowdown continues or trade war gets escalated, there is a sizable risk that the expectations will need to be reviewed to the downside. Consequently, although current valuation still makes equities relatively more attractive in the long term there are potential risks for the short term outlook.

Outlook

Currently, all the technical indicators suggest the global equity uptrend is still intact. And the volatility that started in May is a long-needed healthy correction to relieve extreme investor optimism that dominated the market lately. Moreover, historically such corrections indicated good return potential ahead.

Based on the US stock market data since 1990, when the fear index (volatility index VIX) spiked more than 50% above its 50 day low and stayed there for 3 days, while S&P 500 was above its 200-day moving average, the subsequent return was above average on 3, 6 and 12-month timeframe. For example, when the previously mentioned signal was triggered the S&P 500 averaged a 7.3% gain over the next 6 months compared to a 4.0% gain during any 6-month period.

S&P 500 average performance since 1990

  3 months 6 months 1 year
Performance in all periods 2,0% 4,0% 7,2%
Performance when VIX signal got trigerred* 4,8% 7,3% 10,2%

* - VIX signal is trigerred when the VIX index rises over 50% higher than its 50-day low and stays there for 3 days, while the S&P 500 is above its 200-day moving average.
Source: finance.yahoo.com, Luminor calculations

Although equity price action is strong, indicating continued uptrend, global economic growth is still slowing. This raises investors’ concerns of global recession while many analysts are trying to predict when the slowdown will end. Interestingly, historical data shows that knowing the exact date of the start and end of recession may not help correctly time the market. Looking at the performance of the MSCI World equity index during the OECD defined recessions (a slowdown in economic activity, not necessary meaning a decline in GDP) since 1970 shows that the equity index has actually gained 8.9% on average during recessions. Moreover, out of the 10 cases, only 3 were with negative returns, although the declines were quite significant.

MSCI World equity index performance during OECD defined recessions

Recession start date Recession end date Return
May 1973 May 1975 -16,6%
Oct 1979 Dec 1982 24,5%
Aug 1985 Feb 1987 86,1%
Jan 1989 Jul 1993 13,0%
Nov 1994 Dec 1995 19,7%
Sep 1997 Dec 1998 19,4%
Jul 2000 Apr 2003 -39,2%
Jan 2008 May 2009 -33,8%
Oct 2011 Dec 2012 10,0%
Nov 2013 Aug 2016 5,6%

Source: MSCI, OECD.org, Luminor calculations

Overall, equities continue to offer reasonable risk premium over bonds, making them relatively more attractive in the long term. However, the geopolitical and economic uncertainty has increased resulting in significant risks in the short term.
 

Anton Skvortsov
Investment Advice Development Manager in Baltics

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