Views March 2019

March 2019: The return to normal regime

If you went away on a deserted Island at the end of October 2018 and just came back, the widespread negativity has largely dissipated, and the overall risk environment appears to be more balanced. Sentiment has turned more positive, VIX back to the lows seen last summer (now at 13.6%!), signalling a move towards complacency. But, if you look at the 4 months moves, it has been a wild ride, with one of the worst fourth quarters on record followed by one of the best starts to a new year.

Reading the news, you discover that the Fed made a dramatic pivot in its communication (even talking about an averaging inflation targeting), and investors have finally considered that geopolitical headwinds are nothing new, and while data has generally been mixed, media and strategists tell us that opportunities are coming back for investors to focus on company fundamentals and idiosyncratic stories again. The popular explanation going around is that the fourth quarter sell-off was just a technical event, the result of an unnecessarily aggressive Fed and trade tensions between US and China. With both of those problems now nearly fixed, markets can go back to where we were before these were concerns. As such, new highs for equity indices and tighter spreads for credit can’t be far away.

Our Equity regional matrix is confirming this improvement. For the first time since October, our medium term grade is bullish at 23%, though still in trading mode. A switch to an investment regime would require better trend grades, better economic ones and less complacent sentiment.

Back in november, we mentionned that three fronts had to be solved to let markets go back to an investment regime: Trade wars, a dovish Fed and Opec managing to halt oil sell-off. This trio of factors caused growth outside the US to slow significantly, from a peak of 4.2%Y in 1Q18 to just 3.4%Y in 4Q18. Escalating trade tensions over much of 2018 led to increased business uncertainty and tighter financial conditions, which affected capex decisions and exerted a drag on global growth. This impact was felt most keenly in China, compounding the challenges of its own tightening cycle and triggering a sharp slowdown in demand in 4Q18. This is why as the triumvirat of headwinds have been more or less solved, the real mark to signal a trough in this cycle is China. And indeed, China’s monetary easing is starting to work, with the latest confirmation that broad credit growth picked up in January (a sign that easing is filtering through) and helped to rekindle optimism about China’s growth outlook.

There are many remarkable aspects to the rally over the past two months. One of them is the absence of buying with investors mostly sitting out. The cumulative fund flow in equity mutual and exchange traded funds remains near a five-year low. The knee-jerk contrarian conclusion would be that this is bullish as stock climb the “wall of worry.” That’s a false positive, since bull markets need investors to become more positive, not less. There’s something odd going on it and bears are watching. Then, the thrust in market breadth, and the persistency of it, has been one of the most notable aspects of the past two months. But it’s starting to ebb, as the Smart Index (performance of the Dow without the first emotional hour) has started to de-correlate with the index and our US sentiment indicator is giving extreme bearish signals.

The short term tactical indicators have become toppy, given the strong equity bounce, and are pointing to a near term consolidation. Our matrix tells us that we should be using market weakness as an opportunity to add further, as, the investor positioning is still light. A ytd rebound needs earnings and PMIs to be higher into 2H. This should address one of the persistent pushbacks by bears – still weak earnings revisions. China stimulus shall be the main catalyst for a sustained rally.