Outlook 2018: A Complex Equities De-Rating

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In this week's Weekly Insights (published in two separate parts):

-Outlook 2018: A Complex Equities De-Rating
-Slowing Growth, Rising Yields, High PEs
-Conviction Calls
–Australian Banks: Cheap, But Value?
-Rudi Talks
-Rudi On TV
-Rudi On Tour

[Note due to ANZAC public holiday the non-highlighted items appear in part two on the website on Friday]

Outlook 2018: A Complex Equities De-Rating

By Rudi Filapek-Vandyck, Editor FNArena

Last week's disappointing labour market data released by the Australian Bureau of Statistics mark an important new development for calendar 2018, and an additional complication for global financial markets; economies are slowing down, with synchronised momentum having peaked late last year.

While it remains too early to start worrying about the next recession or global bear market for risk assets, slowing economic momentum when the Federal Reserve remains intent on further tightening ("normalising") US interest rates is not a favourable combination, to put it mildly. This new framework increases the chances for ongoing sharp volatility in markets, if not a much larger draw down in case investor sentiment suffers yet another blow.

Slowing global growth should definitely be on investors' watch as it has the potential to change existing trends, potentially reversing fortune for the US dollar, while keeping a lid on inflation expectations, on 10-year bond yields, and potentially on central banks intentions for the year ahead.

Below are some of the charts that have caught my attention recently.

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First up, economic data have been, on balance, underwhelming over the past 2-3 months, suggesting a global synchronised loss in economic growth momentum is upon us. Nowhere has this slowing in growth momentum shown up as pronounced as it has in the eurozone.

Against this backdrop, respected newspaper columnist Ambrose Evans-Pritchard warned in the Financial Times last week about the German economy potentially heading for a recession. Others have been issuing similar warnings for the US in 2019, but the latter economy, while losing momentum too, currently still looks one of the most resilient worldwide.

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Global manufacturing is losing momentum, and leading indicators are suggesting the weakness is likely to extend into the six months ahead, if not longer. Here investors should bear in mind several PMI indices had previously surged above 60, suggesting almost overheating industry conditions.

Economists, such as those at Danske Bank, are merely anticipating conditions for manufacturers worldwide are now heading towards a more moderate growth framework, maybe with China's PMI index sinking into negative territory again (below 50) by year-end. The underlying suggestion here is that momentum for global manufacturers, while slowing markedly, should remain positive throughout the remainder of this calendar year.

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If everything goes according to plan, the current quarterly reporting season in the USA should reveal the strongest profit growth since 2010. Again, prospects are this season probably represents the peak, but if Morgan Stanley's leading indicator can be relied upon, the quarters ahead will show a slowing in the pace of corporate profit growth, but still show double digit percentages, and that should keep valuations supported.

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It has been pointed out time and time again, Australian households are being squeezed by 3%+ inflation in necessities and 2% (if that) growth in average wages. The RBA makes regular references and just about every economic outlook now contains a reference to the absence of real growth in Australian wages.

Did you know the situation is pretty much the same in the world's largest economy? Real wage increases are notably in decline throughout the USA, and the graph below shows the impact on US retail sales. Prospects for spending by US companies might remain positive, US consumers have been running down their savings without a noticeable genuine improvement in their budgets. Is this the ticking time bomb we prefer not to mention, until we can no longer ignore it?

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Chinese authorities surprised friend and foe last week with the PBoC cutting the reserve requirement ratios (RRR) for domestic lenders by 50bp, effectively loosening monetary conditions. But what does it mean? Not everybody is on the same song sheet, but it is difficult not to place the central bank's move within the context of tighter monetary conditions and slowing momentum for the Chinese economy.

As shown on the graph below, Chinese bond yields have reversed course, heading lower. To some, lower bond yields are the logical precursor to slower economic momentum. Others simply see a logical response to the PBoC loosening. The truth, probably, lies somewhere in between. Many an economist believes China will no longer be exporting inflation to the extent it has.

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On Monday, Macquarie equity strategists tried to sooth investor worries by emphasising they had seen no reason to date to assume the current loss in global economic momentum is the harbinger for a global recession coming. Yes, global indicators are rolling over, and bond yields are on the rise, while geopolitical and other macro threats remain alive, but fundamentals underpinning share prices remain sound, according to the strategists.

Macquarie suggests investors should focus on separating "noise" from "fundamentals", albeit with the admission the global fear factor remains "high". Domestically, the banks are probably due another reduction in profit estimates, acknowledge the strategists, but they don't see a broad based downgrade cycle opening up.

The attempt to provide some positive support when the overall news flow has the potential to darken short term was accompanied by the following table:

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Assuming global momentum is now sliding, and will continue sliding for most of 2018, equities globally will be de-rated, and that's nothing unusual point out strategists at Citi. They too suggest none of this implies disaster lies around the corner. What it does mean is equities are unlikely to repeat the performance from 2016/17; nothing we didn't already know, instinctively.

Of course, there is always the risk that a larger correction might pop up at some stage, in particular if equities continue to move sideways with a lot of volatility. A fact acknowledged by the team at Citi (with explicit reference to midterm elections in the US).

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Finally, while equity markets have faced a much tougher environment during the first four months of the new calendar year, this hasn't necessarily translated into significant losses across the board, for every stock and for all investment portfolios.

Admittedly, being invested has been particularly painful for investors holding shares in Retail Food Group ((RFG)), down -56% in three months, in Myer Holdings ((MYR)), down -44%, in Village Roadshow ((VRL)), down -42%, in iSentia ((ISD)), down -35%, in IPH ltd ((IPH)), down -34%, and in Platinum Asset Management ((PTM)), down -33%, while things have only turned out slightly less painful for holders of shares in G8 Education ((GEM)), Perpetual ((PPT)), Syrah Resources ((SYR)), Vocus Group ((VOC)), Genworth Mortgage Insurance Australia ((GMA)), TPG Telecom ((TPM)), and numerous others.

But the ASX200 Accumulation index, which includes dividends paid, is year-to-date sitting on a total loss of -2%, also thanks to a near 2% positive performance for the first three weeks in April. I think we can all admit it definitely feels a lot worse than those numbers seem to indicate. This is probably due to the fact major banks and large cap stocks including AMP ((AMP)) and Telstra ((TLS)) have been such lousy performers. Also, the ASX200 has to date hardly spent any time in positive territory for the running calendar year.

The FNArena/Vested Equities All-Weather Model Portfolio, which excludes banks, miners and energy stocks, but includes CSL ((CSL)), REA Group ((REA)), Altium ((ALU)) and Xero ((XRO)), among others, is up more than 1% year-to-date, of which some 0.54% was achieved in April. The portfolio performance remains above 10% compared with twelve months ago.

Make sure you read "Slowing Growth, Rising Yields, High PEs" in Part Two of this Weekly Insights.

Below: this year's equities de-rating (with thanks to Credit Suisse).

Rudi Talks

Last week's audio interview about joining this year's upward momentum in oil&gas stocks:

http://boardroom.media/broadcast/?eid=5ad5708d03600639530e914f

The prior week's audio interview about seasonality in the share market, and whether this year might be different:

http://boardroom.media/broadcast/?eid=5acd7619f0a61473eeeeedef

Rudi On TV

This week my appearances on the Sky Business channel are scheduled as follows:

-Tuesday, 11.15am Skype-link to discuss broker calls
-Thursday, noon-2pm
-Friday, 11am, Skype-link to discuss broker calls

Rudi On Tour

-Presentations to ASA members and guests Gold Coast and Brisbane (2x), on 12 & 13 June
-ATAA members presentation Newcastle, 14 July
-AIA National Conference, Gold Coast QLD, June 29-August 1
-Presentation to ASA members and guests Wollongong, on September 11
-Presentation to AIA members and guests Chatswood, on October 10

(This story was written on Monday 23rd April and the first part was published on the day in the form of an email to paying subscribers at FNArena, and again on Thursday as a story on the website. Part two will be published on the website on Friday).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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