Chief Investment Strategist
Summary: The disconnect between macro data and equity markets seems to be growing as equities are making new highs despite weaker macro data and earnings growth going negative in emerging markets and close to negative in developed markets. Equity investors are clearly discounting a soft patch in the economy before returning to trend growth. Our view remains that of being defensive.
October was a mercurial month with global equities rising 2.7% in USD terms despite clear evidence that the global economy continues to slow down. In fact, the global leading indicators from OECD have been declining for 20 straight months. The US chemical industry shows weakness to persist into Q2 2020, South Korea export data shows little signs of rebound in Asia and in particularly China, US employment is slowing down, and earnings growth has gone negative in emerging markets and close to negative in developed markets. The disconnect between what we observe in macro data and equity markets has many explanations but one of them is that equity investors are only discounting a soft patch for the economy before returning to trend growth. This is key assumption so any broad-based weakness in the US services sector and employment in general should in theory in set in motion a repricing of global equities.
This year’s 19% rally in global equities has been fueled entirely by expanding valuation multiples which to some degree can be justified as global interest rates have come down reflecting lower inflation and growth expectations. We observe a clear pattern of lower inflation rate translating into higher valuation multiple. This reflects lower hurdle rate for return on capital for companies but also substitution effects from bonds into dividend paying stocks, something we have talked a great deal about during October in our daily equity updates.
In our Q4 2019 Outlook: The Killer Dollar we also showed how the USD is a key driver of equity returns globally. Our findings suggest in the last three major USD cycles that stronger USD coincide with strong US equity returns compared to developed equities ex US and emerging markets. The stronger USD theme is also important to be watching as the USD is a constraint on financial conditions and global growth. For the time being we remain defensive on equities but will switch to overweight as soon as leading indicators are turning higher again and the USD is weakening.
Given the trajectory of macro data, the geopolitical uncertainty on the rise and a bumpy ride on the trade deal we still have the view that volatility could pick up in November and December although this seems like a contrarian view as equities are climbing higher. The VIX is back to levels around July before the August volatility kicked in. In our view equity volatility is fragile to news on the US-China trade deal and US jobs data out today.
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