Longview on Friday

Below is a round-up of Longview related views/research & trade ideas – the intention is to publish this most Fridays, updating key themes and highlighting key pieces of (often contrarian) research. Feedback, as always, is appreciated. Equally just ‘unsubscribe’ at the bottom if you don’t want to receive the email.

What Kind of SELL-off is This?

Broadly speaking, there are three ‘types’ of equity market pullback: (i) risk events (i.e. principally related to positioning and excessive exuberance coming into the pullback); (ii) sell-offs into a recession related cyclical bear market; or (iii) sell-offs which result from a macro/liquidity shock.

Increasingly, current price action in equity markets is confirming our prior macro analysis (see HERE), that this pullback relates to category (iii). In other words, it has parallels with, most recently, the experience of 2011 & 2015. That is, a large and enduring pullback which, without policy response, has the potential to evolve into something more sinister.

The repeated retest of the initial lows (i.e. from late October) is interesting in that respect and typical of that third category of sell-off. Previous examples of repeated retests include 2H 2011 (during Euro crisis) and 1978 (FIG 1) – just prior to the US's double dip recession.

FIG 1: S&P500 candlestick chart shown with key moving averages: 1978-79

Given that backdrop, our central case expectation is that, after an initial relief rally into Q1, then market weakness will resume. Other observations confirm that expectation. Our global sector momentum model, for example, is only approx. 1/2 to 2/3rds through its movement lower (to levels it normally reaches in a ‘type 3’ pullback). Our safe haven positioning model is also not yet at an extreme, while, tellingly, our sentiment scoring system is currently mid-range (see FIG 1a below). In large/enduring sell-offs, this model works its way back to below -1 standard deviation. All of that supports the expectation that further market weakness in Q1 is likely.

FIG 1a: Longview sentiment indicator vs Global S&P1200 index

Whether that weakness is forthcoming will hinge on the behaviour and signalling of the Fed and other central banks (next week and in coming months). As argued in this publication two weeks ago (see HERE) another Shanghai accord is required (to trigger global reflation and extend this global economic cycle). Indeed all the major central banks, in our opinion, need to significantly change their approach to policy: The ECB needs to generate more liquidity (e.g. as evidenced by the EZ banks poor stock market performance as well as by slowing money growth); China needs to stimulate in a much more dramatic way than it has been (e.g. see HERE); while the Fed needs to go on an extended pause, stop shrinking its balance sheet and possibly even cut rates. While the US isn't at risk of a recession (at this juncture – see below for detail), growth is slowing, inflation is muted and the oil price is down sharply (i.e. suggesting future inflation will soften). Over and above that China needs ‘Fed cover’ to dramatically ease its policy (something which we believe Powell understands) whilst the US's own financial conditions are also starting to tighten. This is most obvious in corporate debt markets where spreads have widened in recent weeks. It’s also happening in the less widely watched leveraged loan market where prices are down sharply (FIG 2). With this market accounting for a major portion of loan growth in the US since 2009, the Fed will likely want to ease up on monetary conditions in order to ease up on financial conditions and support the economy. If markets sell off again in Q1 2019, that case is likely to become more compelling.

FIG 2: US leveraged loan price index (mkt value weighted)

How High is US Recession Risk?

With the US yield curve inverting at the 2s5s & 3s5s spreads, market participants have begun discussing US recession risks. Naturally, negative news flow around trade and sharp moves lower in global equity markets (and oil prices) have added to those concerns.

With that inversion, though, key questions are being asked about this indicator. In particular: ‘Is it different this time?’ (with the curve distorted by low term premia, as Brainard and others argue – see her speech HERE); or, does the shape of the curve nevertheless remain an accurate barometer of the tightness of US monetary policy? The evidence suggests it’s the latter (as we show HERE), although it’s important to note that it’s only the 2s5s and 3s5s part of the curve that has inverted. The other parts remain upward sloping. Also, of interest in that respect, a number of other key indicators have the same shape as the 2s10s part of the yield curve and therefore have the same message. Those indicators include M1 money supply, US ‘home buying conditions’, and US consumer confidence (expectations less present situation, FIG 3), amongst others.

FIG 3: US yield curve (2s10s) vs. US consumer confidence expectations less present situation

While the yield curve therefore bears watching closely, its recession signals typically occur with long lead times (i.e. recently as long as 2 years).  Furthermore, we’d expect an inversion, as and when it happens, to be accompanied (and confirmed) by broad based evidence that financial, monetary and credit conditions across the spectrum have reached ‘recessionary tight’ levels (e.g. senior loan officer surveys). That’s typical ahead of recessions but is not currently the case (see our forthcoming US macro update for detail).

Also of note, recessions aren’t just about the overtightening of money. They’re brought about by corporate sector retrenching, always from an overstretched cash flow position*. Indeed, never in post WWII history has there been a recession when companies are throwing off free cash flow.

Last week’s ‘Flow of Funds’ update from the Fed is interesting in that respect and shows that companies are NOT currently overstretched (i.e. despite a deterioration in Q2 & Q3, companies are still throwing off free cash flow, see FIG 4).

FIG 4: US corporate sector financing gap (% of GDP) NB scale INVERTED

*With retrenching usually triggered by the overtightening of money, or some sort of shock.

Of interest, in Q3, companies appear to have conserved cash (principally by reducing M&A activity – see FIG 5 below).

FIG 5: US net new equity issuance (US$tn, qtrly annualised data)

That saved companies $578bn of free cash flow in Q3 (relative to Q2). Adjusting the classically calculated corporate financing gap to reflect that then the corporate sector’s cash flow deficit improved in Q3 (and is now close to relatively neutral levels – see FIG 6).

FIG 6: US corporate financing gap – shown after accounting for share buybacks (as % of GDP)

In a cyclical sense, therefore companies have a relatively healthy cash flow position (and are unlikely to retrench). Our ‘margins model’ for the US corporate sector confirms that message, i.e. that corporate sector health (cyclically) is relatively good (see FIG 7 below). This indicator measures the difference between nominal GDP growth (i.e. as a proxy for revenues) and growth in unit labour costs (i.e. the largest/key cost for companies). In recent quarters, this barometer of margins has accelerated (highlighting the easing of pressure on margins).

FIG 7: US corporate sector ‘margins model’ (nominal GDP LESS unit labour costs, pp.)

Clearly part of that reflects fiscal stimulus (i.e. strong GDP growth) which has now past its peak impact on GDP, reducing this quarter and next. Of note, though, households are demonstrating a reasonably high propensity to consume (rather than saving their higher wages/tax cuts). Retail sales, for example, have picked-up, restaurant sales have been strong (FIG 9), and so have some measures of discretionary spending (e.g. see cinema sales, FIG 8). Arguably, therefore, higher wage growth is unlikely to simply squeeze margins (as revenue growth improves at the same time). Likewise, the recent pick-up in productivity growth, if it continues, also supports the case for healthy corporate sector margins.

FIG 8: US cinema ticket sales Y-o-Y % (6 months smoothed)

FIG 9: Restaurant sales (6 months smoothed), Y-o-Y %

Copper Price: Downside Breakout Likely

Below is an extract from this week’s commodity research:

Summary

The debate around copper price direction is finely balanced. The bulls point to falling capex, falling ore grades, and ongoing demand growth (driven increasingly by an ‘electric car revolution’). More importantly, they also make the case that the Chinese authorities are close to pulling the trigger on significant stimulus/policy easing. In the absence of that stimulus, though, we find the bearish case for copper (at least into 1H 2019) particularly compelling (see Overview below).

Of interest in that respect, a pennant formation in the copper price has emerged over the past 6 months (fig 10). Usually, such formations are followed by significant breakouts. At this juncture, and in the absence of a meaningful change in Chinese monetary policy, the breakout is likely to be to the downside.

Fig 10: Copper price (candlestick shown with 90 & 200 day moving averages), USD/lb

Overview

China consumes 50% of the world’s copper. Broadly speaking, that can be broken down into: (i) infrastructure for power plants (50%); (ii) construction (20%); and (iii) general use (30%), e.g. in manufacturing, electrical goods and so on. In the absence of significant policy easing, all three of those key sources of Chinese copper demand should weaken in 2019. As a result, and given strong/ongoing production growth, a global copper supply surplus is likely in 2019 (i.e. of around 340k tons).

(see HERE for full analysis)…

Have a great weekend.

Kind regards,

Longview

Longview Research recently published

This week:

Global Valuation Chartbook, 14^th December 2018:

“Is anything compellingly cheap?” – available HERE

Commodity Fundamentals Report No. 89, 13^th December 2018:

“Copper price: Downside Breakout Likely” – available HERE

Weekly Market Positioning Update, 10^th December 2018:

"Positioning changes unusually mixed"

Last week:

Extract from Quarterly Global Asset Allocation No. 36, 7^th December 2018:

"China: Where’s the PBoC’s Tipping Point?" a.k.a. We need another Shanghai Accord – available HERE

Tactical Equity Asset Allocation No. 179, 5^th December 2018:

"Stay Tactically OW Equities - Year End Rally Likely" – available HERE

Macro Trade Recommendation No. 95, 4^th December 2018:

"GOLD: Start BUILDing LONG exposure" – available HERE

Weekly Market Positioning Update, 3^rd December 2018:

"Record SHORTs in 2 year Treasuries"