November was a stark reminder of what econometrics have coined "volatility clustering" – the observation that once the market sees big swings, the volatility continues for a while before transitioning into a less volatile state. Last month, global equities rose 1.1% while experiencing a 5.1% move from the peak to bottom as headlines rolled in concerning Trump’s threats of higher tariffs on Chinese goods and GE creditworthiness wobbling scared investors in credit markets. The month ended with a rally as Fed chair Jerome Powell reversed his language on the future level of the Fed Funds Rate,
as we elaborated on last week.
With investors in general interpreting Powell’s speech as dovish and implying fewer rate hikes in 2019, global equities rose 2.1% into this weekend’s important G20 meeting and Trump-Xi dinner. Powell’s speech made us increase the potential short-term for equities by twp percentage points. Over the weekend, investors got another dose of positive news as Trump and Xi agreed to a “ceasefire” in the ongoing trade war. I had only put a 25% probability on this event in my recent presentation and judging from the market reaction overnight, the market in general had not priced it in. Based on recent events, we expect global equities to rise by 5-7%, so with today’s 2.5% move in global equities almost a third has already been achieved.
The broader question is whether recent events set
equity markets up for a rosy 2019. We remain sceptical of this projection despite our current short-term positive outlook. The global economy is late stage and financial conditions have tightened above the historical average. Equity valuations are not outrageous, but they are not cheap either. Our biggest worry is still credit markets that look very vulnerable due to the significant increase in corporate bonds.
The BBB segment (one notch above junk status) has grown massively – by almost $2 trillion – and several observers of the market including Barclay’s CEO Jes Staley have noted wariness on this market. If we suddenly experience a wave of downgrades it’s questionable whether the market can absorb this without significantly tightening financial conditions even further.
It was positive to observe the Fed putting more weight on the market than the economy in trying to indicate that US rates are close to neutral. Previously, the Fed has focused too much on macro indicators late into the macro cycle, but these are useless as they are backward-looking. Late into the macro cycle, a central bank should pay more attention to markets for clues about financial conditions, credit markets, impact on asset classes from discounting recent rate hikes, et cetera. Overall, we believe December will be a good month for equities as the Fed and the G20 came to the rescue and offered a good excuse for investors to increase exposure in equities as 2019 approaches.
Introducing new equity market and industry models
We have lacked a more systematic approach to how we look at equity markets and industries, so today we officially launch the models that will underpin our house view on equities. They are not meant to be fancy – they are simple and focused on clarity and transparency.
The universe is all developed equity markets and the six largest emerging markets adding up to 29 markets in total. The model looks at each market as if it were a single stock (an equity market is just an aggregation of single stocks). We use the two classic equity factors of valuation and momentum to supplement each other; historically, cheap valuation precedes good returns and momentum is the effect wherein stocks that have done continue to do well on average. Valuation is measured on EV/EBITDA, and against the market itself rather than not cross-sectionally. Why? Because just like auto stocks are always “cheaper” relative to software stocks, it is not so much the relative valuation that matters but the valuation relative to itself (mean reversion). This is because there are always key drivers/factors for a valuation spread (capital structure, accounting rules, growth etc.). Momentum is the 12-month total return in USD minus the one-month return (this is done to factor out mean-reversion effects).
But why have we included momentum when we just trashed it in October? Going forward, momentum strategies will disappoint on their own due to crowding out effects from quant funds following this factor. However, this effect is mostly used on single stocks in the equity realm. Combining it with another factor also makes the model less dependent on momentum itself. So we use momentum because we believe it adds value
in combination with another factor. As a stand-alone factor, however, the future is dim for momentum.
As the equity market model below shows, the most interesting markets are Australia, Brazil and Sweden – all very cyclical economies with links to China. With the current ceasefire and likely risk-on through December, these markets should represent a positive risk-reward ratio. The worst markets according to our model are Italy, Denmark and South Africa. Also, note the difference between the Hong Kong (overweight) and China (underweight) markets; the model basically suggests to get China exposure through Hong Kong.
