First it was Goldman [12], then JPM [13], then Credit Suisse [14], and now it is Citi's turn to turn decidedly downbeat on stocks for next year and just cut its weighing on global equities to neutral. The main reason for Citi's bearishness, it is the same as the one we noted two months ago [15], and again last night: margin sustainability, and rather the dramatic drop in corporate profits in recent months.
[16]
As a reminder, overnight we pointed out that according to Credit Suisse, "equities peak 12-18 months after a peak in margins" and "we are now 15 months after the peak in margins."
[17]
Cue Citi:
In the US our chief concern is margin sustainability. Corporate profits as a share of GDP have been at all-time highs, which is just another way of saying the rewards to labour have been at all-time lows. But change may be afoot in the form of modest labour market tightening in the US. It is too soon to see this show up in core (ex Fins, Energy and Materials) margins in the US (Figure 13, LHS) but that may be where things go. Modest nominal wage acceleration combined with global disinflation (price taking by US firms) and lack of productivity growth may mean margins come under pressure from labour costs.
[18]
Citi's contention - the pendulum is swinging away from Wall Street and back to Main Street:
US business surveys increasingly seem to be highlighting labour costs as a factor affecting future prices (Figure 14, LHS). Non-labour related costs don’t seem problem for businesses, which stands to reason given commodity price trends. It is also true that 2014/15 optimism regarding sales and margins seems to have waned (Figure 14, RHS), quite materially so in the case of sales.
[19]
Alas, one can't pay workers with expectations of margin increase and goodwill. Whether these "expectations" actually materialize in higher wages remains to be seen, but Citi does not plan to hang around and find out:
Given the surge back towards the all-time highs in the S&P 500, we think that the best might be over for US equities and that indices might range trade more in 2016. We have downgraded US equities to neutral. This takes our overall equity weighting down to neutral, in many respects an extension of what we’ve been doing for most of this year as richer and richer asset markets, against a global background of economic risks, have made us more cautious.
As a reminder, Citi's equities downgrade follows a report by Citi's rates team according to which the probability of a recession in 2016 has soared to 65%. Here's why:
If this were a typical policy cycle after a typical economic cycle, the Fed would have already raised rates 2-3 years ago. Instead, the US recovery is set to enter its seventh year while the European recovery is still embryonic. So in addition to China sneezing, FI markets need to price the longevity of the cycle. There are two approaches.
1. Cycle probabilities
Firstly, a statistical approach is shown in Figure 46 and highlights the cumulative probability of a recession based on data from 1970-14 across US, UK, Germany and Japan. As the U.S. economy enters year seven, the cumulative probability of a recession in the next year rises to 65%.
2. The economy continues to expand ….
The sub-title above would seem to contradict recession risk – but that is not the case – as an ongoing improvement in unemployment risks recession unless we are to believe in a soft landing. Consider the extrapolation of the U.S. unemployment rate drop on the trend since 2012.
- That would take the US U-3 unemployment below 4% by end 2016. Unless, there is a soft landing, the market will price both front end hikes but also a major flattening of the curve, to augur higher recession risk. Watch for flat forwards initially and then some inversion quicker than consensus prices.
How does this stack up in outright rates? The historical record is shown below for Treasury implied 5y5y rates.
- The median line shows that even against a time trend to account for the secular bond market rally that 5y5y Treasury yields move lower.
So is there a two-thirds chance the US economy contacts next year? According to Janet Yellen, who was asked precisely this question during her hearing in Congress today, there is no risk: according to her, she doesn't see the recession risk as "anything close" to 65%. She did not provide a number which she thought is more appropriate.
She also said that the FOMC would only raise rates as long as policy makers think U.S. will "enjoy at least some above-trend growth" that would result in improving labor market..
Her conclusion: if the rate hike results in "unintended consequences" the Fed can always just lower rates. Which incidentally is precisely what the Fed did in last 1936 when it, too, erroneously decided the economy was strong enough to sustain a tightening of financial conditions...
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... only to cut immediately. The collateral damage? The Dow Jones plunged 50% the next year...
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... and unleashed a severe recession in the second half of 1937, followed a few year later by the start of World War II.
This time is not different.
