This column is being published later than usual. So much was scheduled to happen over the last two weeks that we believed it would make far more sense to take the outcome of those events into account. These included the visit of China’s Vice Premier Liu to the US on 10 October, which led to a delay of the tariff increases expected on 15 October, and the UK Parliament’s vote on Brexit over the weekend, which sent Prime Minister Johnson back to Brussels to ask for a delay.
We conclude that, while we don’t have much more certainty than we had ten days ago on either trade or Brexit, we do have a better understanding of how far some of the parties involved are willing to go to get to a resolution.
For all of his tough talking about a no-deal Brexit, Boris Johnson has worked hard to solve the issue of the Irish border and put another deal on the table. Except for the border arrangement, the rest of the deal doesn’t seem to differ from what former Prime Minister May had proposed.
One would be forgiven for thinking that Mr. Johnson would rather not go down in history as the man who crashed the UK out of the European Union. Or maybe it is just the formidable pressure applied by the British Parliament that put a possible Brexit deal on life support. That said, the odds of a no-deal Brexit remain high, if not by end of October, then possibly by the end of January 2020.
President Trump, on the other hand, is in the midst of an impeachment process, facing backlash from his own party for withdrawing troops from Syria, and there are signs of a US economic slowdown. The latter is probably Mr. Trump’s biggest worry, as a negative impact on the US stock market’s performance could make some of his constituents turn away from him. He appears more keen than ever to show that he has ‘made the deal’ with China.
If anything, China is now the one playing hard to get. The Chinese administration knows that no deal is secure with a volatile Trump. Most likely, President Xi is watching President Trump’s approval ratings closely, hoping that the more controversy he steers and the weaker the US economy becomes, the less likely he is to get re-elected. Let’s face it, a new President, whether Republican or Democrat, would probably be as hard on China, but also far less volatile and more reliable in the negotiation process.
In all of this whirlwind of contradicting news, the market seems to have created a new investment style
Forget all the talks of value versus growth and momentum that we have heard to exhaustion over the last few weeks, and welcome to the brand-new pinball style. In a world of binary outcomes, markets have been bouncing off tweets in whichever direction makes more sense at the time. The trade deal is on, equity markets are up and risk-on trades outperform; the trade deal is off, equity markets are down and turn more defensive.
This has been evident from the direction of the market since early September, when the resumption of the trade talks was announced. Since then, the US equity market has underperformed Japan, EM and Europe, and the value style has made a comeback across all those markets. Admittedly, the outperformance of value was more convincing in September, but it has continued to defend itself in October as well. The value vs momentum reversal was particularly dramatic in the US in September, which is to be expected as the correlation between value and momentum is at near 30-year lows, i.e. value appears extremely oversold.
Neither the outperformance of value nor the outperformance of equity markets outside of the US have been too convincing. This is not surprising, as global growth and earnings continue to deteriorate, with earnings revisions worsening across all major regions. Therefore, for either value and equities outside the US to show a more convincing outperformance, we need to see some macro improvements or – at the very least – some positive news on the trade front that would make those macro improvements more likely.
In this apparent see-sawing madness, the latest market movements have shown us is that investors are ready for a change
However, in this apparent see-sawing madness, one thing that these latest market movements have shown us is that investors are ready for a change. They just need a trigger. A Phase 2 of a trade deal would most likely spur EM and Japan further and, unless Brexit were to end in a mess, Europe would also follow. US equities would underperform and – within markets – risk-on trades including value and cyclicals would finally be in favor again.
Of course, no resolution or a meaningful setback in the US-China negotiations (such as a resumption of the planned tariffs) would bring the risk-off stance back, with global equity markets underperforming other asset classes and, within equities, the US market and more defensive bets would most likely prevail.
The binary outcome is reflected in our investment team’s five-factor outlook, which is now neutral for both developed and emerging equity markets. The neutral conclusion indicates that the pinball could bounce off the next set of tweets and news flow in either directions. Yet, while the news outcome might well be 50:50, the risk-reward is asymmetric. Markets outside the US have already priced in a lot of uncertainty, and earnings growth (or lack thereof) is now at levels that do not justify the wide disparity in valuations.
Take EM, with an expected earnings growth of 2.3% for 2019 and a PE of 13.2x versus the US’s 2.3% and 18.6x respectively. For Japan and Europe, earnings are expected to fall by 0.9% and grow by 1.3% respectively, priced at a P/E of 13.7x and 14.8x respectively. While further degeneration in either the trade war or – limited to the UK and Europe - Brexit is likely to cause a negative price reaction, the upside that would be triggered by positive news at this point looks far greater.
The upside that would be triggered by positive news looks far greater
Clearly, the next question to answer is: would a risk-on sentiment triggered by positive news on the trade front last? It would all depend on how quickly the global macro backdrop is able to recover and, with that, corporate earnings. With the world’s major central banks remaining supportive and the Chinese government continuing to gradually stimulate the domestic economy, we just have to hope that the positive market momentum lasts long enough to give corporates time to resume their spending plans.
At this point, we don’t know if we will have a trade deal any time soon. What we can tell is that the pinball is eager to bounce off in one direction. Needless to say, a trade deal now does not solve what are likely to be long-term strategic tensions between the US and China. These will likely remain for the foreseeable future, as the competition between the two countries and technology security will be long-term issues.
Yet, it is difficult to see now any measures that could have the same crippling effect on global growth than up to 25% tariffs on more than USD 650 billion in US-China bilateral trade. Let’s see where the flippers and bumpers of our pinball machine take equity markets next. One thing is for sure, if they flip equities in the direction of positive outcomes, market dynamics are ripe for a game-changing bounce.
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