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BookmarkLess than 24 hours ago we presented the latest reason byJPM’s Mislav Matejka explaining why the equity strategist refuses to buy this market, to wit: “equities are down ytd, but notably the ’16 P/E is not much cheaper today than it was at the start of the year. In fact, for the US, the P/E multiple is currently higher than it was on 1st January, at 16.8x vs 16.6x then.”
Fast forward to today when we read something rather stunning: in a dramatic conversion, after moving to Netural on equities just a month ago, JPM is as of this moment underweight equities “for the first time this cycle.” Additionally, JPM is also Underweight such highly correlated to stocks (and China) commodities as gas, oil, and copper, but in a surprising reversal is now, perhaps most importantly, overweight gold.
The details from JPM’s Jan Loeys:
Equities, credit and commodities have all rallied in the last three weeks, as some of the immediate threats to the world economy have faded from attention, possibly only because the bad earnings season has wound up. But, to us, the fundamentals of growth, earnings and recession risk have not improved, and if anything have worsened. We remain wary of the near-empty ammo box of policy makers.
Our 12-month-out US recession odds have risen to 1/3, while equity-implied odds have instead fallen to near 1/5. But even with no recession this year or next, we see US earnings rising only slowly by low single digits and see little to boost multiples. The eventual recession should bring US stocks down some 30%, creating a strong downward risk skew to returns over the next few years.
How to trade’s JPM’s new reco: “We use the rally in stocks to sell it and go underweight stocks, versus HG corporate bonds and cash. The strong rebound of the past few weeks does create near-term momentum, and thus keeps our first UW small. Low growth and easy money and the reduced potential for capital gains should raise the demand for income. We focus this on US HG given its still over 4% yield, a rarity in the HG world. We are not ready to pursue FX or commodity carry at this point, but like high-dividend stocks. Within fixed income, we are now long duration.”
But most stunning is that in the overall asset allocation we spot the following (bolded and underlined):
Our portfolio is now 5% UW Equities, the first UW this cycle. We retain a 10% OW of Credit, moving Bonds to Neutral, and Cash to OW. Commodities stay UW, but we move it to a small -1%, given recent momentum and volatility. Within Equities, be OW defensive sectors. Given that our risk focus is now switching from Chinese debt to US corporate caution, we go OW EM equities. In Credit, OW US HG, US banks, and sterling HG against EUR and EM. In Commodities, be short gas oil and base metals but OW gold.
The full breakdown:
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And some more details from the report:
•We go Underweight Equities for the first time in this cycle.
•Equity bearish forces include poor macro valuation vs. our recession risk for this year; negative fundamental momentum; and limited profit and return upside relative to the downside we see from the eventual recession.
•The limited upside we see on stocks under our no-recession modal forecast is driven by still dismal productivity growth and the inability/unwillingness of monetary and fiscal policy makers to stimulate growth.
•Within equities, we are now OW defensives and large caps, but go OW EM as risk focus is now on the US and away from China.
•We retain an OW of HG corporate debt given its better macro valuation and better ability to absorb negative economic news. Move long duration in global bonds.
•OW Cash, but stay UW Commodities, though cut in half.
After January’ traumatic start for risk markets, early February brought another low, but was then followed by a rebound over the past two weeks that pushed global stocks within 4% of their start of the year level. Commodities did virtually the same, with oil still net down but industrial metals net up on the year.
From risk-on/risk-off to recession-near/recession-far. The debate among investors is not about whether we are in a risk-on or risk-off mode, but whether we are nearing a recession or are still far off. The end-of-cycle scenarios we have discussed here since early last year started with a Fedbehind- the-curve-on-inflation, to a China and EM debt crisis, and then more recently to one focused on US corporate caution, driven by falling profit margins and a policy maker without ammunition to counteract corporate retrenchment.
Market participants focus on the binary risk of recession or not because they know that risk markets – equities foremost, but also credit and commodities – have a cyclical pattern and see their greatest price falls generally in a US recession.
Over the past half year, investors have been toggling between these three “economy killers”, trying to judge odds of each over the next year. The generally weak tone of Q4 earnings reports across the DM world in January and early February raised the risk of corporates retrenching in response to falling profits. When the bad earnings news stopped, only because the earnings season wound down, risk markets rebounded, supported also by news that China started injecting more liquidity and credit into its economy, thus reducing downside risk perception. Soothing Fed language and the resulting rally in US duration also helped.
The issue for investors is never whether a recession is coming. In a sense, it is always is coming as no economic expansion lasts forever. The issues are instead when is it coming; how much damage it will do; and whether markets still have enough upside before the recession to make up for the eventual losses during the downfall.
As we have discussed here frequently, US equity markets have in the post-war period never reached their highest level more than 13 months before the onset of recession. This is largely because there is little visibility more than one year out, and there has at least in the past generally been the conviction that if a shock were to hit the economy, policy makers would have time to provide sufficient stimulus to offset its impact.
Our economic models, based on past relationships which have never seen a US expansion lasting more than 10 years, are giving us now a 1/3 probability that the US expansion will end within 12 months, 2/3rd within 2 years, and close to 100% within 3 years. The latter should in reality be lower, as other countries have seen expansions last more than 10 years, and the post war US experience has seen only 10 cycles.
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If the next 12 months also do not produce a recession, then profits should rise again, but probably only by low single digits gains, unless the economy would suddenly show a significant acceleration in productivity growth, something that would be quite a surprise given lackluster growth the past 5 years. As a result, in the no-recession scenario for the next two years, US earnings are unlikely to grow much faster than 5% pa, without a significant acceleration in growth.
It is always possible that equity prices will rise faster than earnings on optimism that tends to rise late cycle. Here we run into the problem, though, that such optimism and multiple expansion face the growing realization among investors that monetary policy makers are running out of ammunition and that new policy innovation from here might not have much impact, assuming it even does not do more damage than benefit. Fiscal policy stimulus in DM, aside from China, will probably only be used after economies have already fallen into recession. Hence, we are loath to rely on multiple expansion as the driver of higher equity prices at this point.
If the upside is limited, what is the downside in the eventual recession? We discussed last month that, during a recession, US large-cap are likely to drop by close to the average recession fall of 32% seen during the postwar period, given its multiple at the peak, the depth of the recession and the likely fall in earnings. Given the reduced leverage in the US economy among banks and households in this cycle, we expect any recession to be shallow. But the lack of immediate monetary stimulus in such a scenario at the same time tell us this recession may be drawn out, giving us a peak-to-trough fall that may well be similar to past recessions.
If the recession starts this year (not our modal view), then the S&P500 would likely fall some 30-35% from last year’s peak of 2,134, to somewhere between 1,400 and 1,500. If instead the recession is in one of the following two years, then we would expect the same % falls, but from levels that would be 5-10 % higher than today and thus to levels still well below today. Hence, we have a view that upside from here is not very great and that eventually over the next few years, we should be some 20% lower than today. The modal price year-end forecasts of our DM equity strategists are near today’s levels, but each sees a significant downward skew around these.
How to invest with a downside risk view on global equities? The first we have done here is to go Underweight equities in a global cross asset portfolio, after last month having gone to Neutral. In our long-short, we were already short US equities versus US HG credit spreads, volatility weighted, and add now a short US equities against US HG corporate bonds, also volatility-weighted.
Within Equities, we are OW two defensive sectors, US large caps versus small caps and global Defensive versus Cyclical sectors. Given the now concentrated focus on US economic risk and some signs of monetary and fiscal policy stimulus coming in China, we go OW EM equities versus DM. The EM-DM split has not shown much directionality in the past and we think EM can outperform even in a bearish environment for global stocks.
In Bonds, we are now long duration, not just to match our equity bearishness, but also as our rule-based models provide a long-duration signal.
We have been UW Commodities and in particular oil, on a view of systematic excess supply of crude. We still have this view but find that oil prices have now been moving up over the past 6 weeks by a cumulative 25%. Part of this is due to the same reduced economic fears that may be driving stocks up over the past few weeks. Given the still high correlation between stocks and oil and the likelihood that some of the recent rebound in oil is due to supply disruptions in Iraq, we reduce the size of our oil shorts.
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Stay long Dec’16 CME gold
At the end of January, we marked our gold price forecasts higher on a delayed Fed hike and USD decoupling with our 4Q2016 average now at $1,250/oz Moreover, NIRP policy ex-US and stickiness in US inflation could push US real bond yields lower and further support gold prices as gold’s best performance has historically occurred during a low and falling US real interest rate environment, with monthly returns averaging 1.4% compared to the long-run average of 0.4%
Went long Dec’16 CME gold at a price of $1,194.60/oz on February 10. Trade target is $1,300/oz with a stop at $1,015/oz. Marked at $1,233.80/oz on March 1 for a gain of $39.20/oz or 3.3%.
By Tyler Durden
Created 03/03/2016
