Liquidity and the FedEx Dichotomy

Equities continue to rally hard, despite pausing for breath today. Sentiment across global markets remains optimistic with broad based buying in play as a string of record highs set for US equities leads the march higher. Australian stocks are no exception and Monday saw the ASX rake in its best 1 day gain since the ScoMo election win, pushing the index back within a stones throw of its closing record high of 6863.99, hit on November 28^th. Friday’s triple witching may temper gains towards the end of this week, but the stage looks set for equities to grind higher into next year as we touched upon earlier in the week.

• Political risk premium has been significantly reduced with less Brexit and trade uncertainty as we move from escalation to de-escalation and the risk of immediate tariff hikes is removed. As we wrote last week with SKEW at a 1 year high investors were positioning for tail risk materialisation and with the risk of December tariff hikes and a Corbyn government off the table that positioning is being flipped adding to bullish moves.
• Green shoots are now firmly in focus as investors reprice the fears of yield curve inversion earlier this year and an impending recession.
• On top of that, adding to bullish sentiment, a whole host of central banks remain in easing mode and rate hikes/”normalisation” of monetary policy come with an increasingly high bar.
• Monetary policymakers have already exhibited, by word and action, their willingness to step in with added stimulus measures in an attempt to extend the cycle. 85.6 percent of all changes by central banks to their monetary policy stance this year have gone toward easing rather than tightening.
• But most importantly, liquidity, a primary driver of asset prices is on the up, meaning the current environment is supportive of higher equities. The Fed will be flooding the market with $500bn of liquidity over the next month through temporary repos, expanded overnight repo and monthly Tbill purchases and by mid-January the Fed’s balance sheet will surpass its record high of $4.5trn.

The danger lies in how consensus that positioning is, but with liquidity being a primary driver of asset prices and Fed injecting approximately $500bln over the next month, stocks should push higher. Meaning 2020 will begin on a very different footing to last, without a large correction in valuations or peaking pessimism, but instead extended valuations and substantial optimistic assumptions as a lot of the positives are already discounted with the large majority of gains driven by multiple expansion. Monetary policy is a powerful determinant of asset prices, and one thing QE and financial repression has taught is asset price inflation. Obviously the inability of such policies to produce a self-sustaining revival in growth, without stoking record wealth inequality, social unrest, and global political risk is a problem for another day. At which point, the answer is likely more of the same liquidity injections!

As positioning continues to turn more bullish, the present environment risks a return to the euphoric sentiment, or melt up scenarios that have previously ended in tears, cue 2000 and 2018. Although, if history is anything to go by, not without further upside for risk assets throughout Q1 2020. In 1999 the Federal Reserve Board approved a special loan facility to ease any liquidity pressures on banks that may have arisen into year end, which sent the Nasdaq surging higher into Q1 2000. Indeed, the current divergence between valuations and underlying income is likely rivalled only by the dynamics of the year 2000. Given that we believe monetary stimulus to date will not be enough to produce a prolonged recovery in growth and return to trend levels, so unlikely to do more than stabilise growth at low rates. Once growth concerns materialise again in 2020 that will not be supportive of current projected EPS growth assumptions. The outlook for earnings remains challenged, particularly in the US as labour costs rise and for Australia, with ASX stocks on course for the Asian regions worst profit growth next year as growth continues to disappoint. Although buybacks no doubt add an underlying support to the US story. Come February reporting season in Australia market performance and economic realities may be forced to converge once more.

FedEx today is a perfect example of that dichotomy between bullish market sentiment and underlying fundamentals and earnings growth. In after hours trade today shares took a hit after FedEx issued its second warning for fiscal 2020 profit. “We incurred peak ramp-up costs in Q2, with none of the revenue benefit,” Rajesh Subramaniam, FedEx president said on a conference call with analysts.

As we enter 2020 the key test will then be whether green shoots actually translate into a return to trend growth, and whether the narrative of receding geopolitical risks can be maintained.

The truce is good news for global economy, and the threat of further tariff hikes is significantly reduced which is important for maintaining supportive environment for the reflation/green shoots narrative and stabilisation in growth into 2020. However, details are scant, Chinese purchase commitments are ambitious and the process seems messy an uncoordinated with no finalised legal text. Agreeing on the translated legal text alone, will likely be no mean feat. The bad news, the deal stands a chance of not entering into force as there already seems to be differences between what the 2 sides are purporting is included. And although details are light, it doesn’t look like anything new has been brought to the table and the deal largely consists of and repackaging reforms already in the pipeline that China was moving toward anyway. The ambitious purchase commitments seem unlikely to be reached and it would be misguided to assume President Trump who has built his legacy on standing up to China will let noncompliance slide. Meaning the risk of another break down is not negligible. Tariffs remain, the US average tariff on imports from China will fall only a small amount to 19.3%, from current level of 21.0%. The trade war persists, and the relationship has suffered permanent damage. The ongoing technology war remains and bifurcation is a key risk, although perhaps remains something more abstract for financial markets (at least for now).

US foreign policy remains unpredictable and with the phase 1 deal out of the way and USMCA done, there is nothing stopping President Trump from turning his attention to Europe once more.

The US elections bring with them a host of risks, notably a Warren candidacy would be particularly market unfriendly.

And on growth, which continues below trend, we have been here before in terms of green shoots, only to see them trampled on. An ongoing inventory rebuild and correction will add to the stabilisation story in early 2020. But the current stabilisation more likely represents a mini reflation within an ongoing late cycle slowdown in growth, which will likely re-appear by 2H2020. The Phase 1 deal is unlikely to be enough to truly revive animal spirits and reignite capex, it is not comprehensive enough and does not include enough roll back of tariffs. China’s structural rebalancing of growth toward domestic consumption and services will continue to pressure the growth and inflation outlook globally. China is no longer the driving engine of global growth with huge credit fuelled stimulus packages ready to reignite reflationary pulses. Leading indicators of employment in the US continue to deteriorate, so whilst green shoots may be driving sentiment now, it is the time to remain avidly data dependant. We remain sceptical in the ability for monetary policy to truly revive growth sustainably without the complimentary push from fiscal policy.

Once these concerns build again in 2020, market performance and economic realities may be forced to converge once more. But, monetary policymakers have already exhibited their willingness to step in with added stimulus measures in an attempt to extend the cycle. And whilst any correction may be painful, the continuing low yield environment, means we continue to see any corrective moves, whilst painful, being bought as investors sitting on the sidelines with dry powder step in when valuations correct enough. When it comes to fiscal policy, once growth lags once more, the push for action from fiscal policymakers will grow louder. But given the present reluctance, more pain in markets or economic data will be needed in order to force capitulation.