It didn't take long for the momentum-chasing fundamental strategists to readjust their immediate stock price targets on the heels of the i) failure of the Santa Rally and ii) the worst start to the year in Chinese stock market history. Case in point, moments ago JPM's equity strategy team released its first note for the year in which it says that "we take the view that equities are unlikely to perform well on a 12-24 month horizon" adding that "the regime of buying the dips might be over and selling any rallies might be the new one."
According to JPM, the following are the headwinds faced by stocks:
1) Equities are not attractively priced any more. On most metrics, P/S, P/E and P/B, they are trading at a premium to their historical averages. Sales per share are at highs, as well. True, relative to fixed income, stocks still look interesting, but credit spreads are widening, and the key central bank has started to hike. Asset reflation regime might start to reverse.
2) Balance sheets are deteriorating, with increased debt issuance used to finance record levels of buybacks. US corporate financing gap has turned negative. This is typically not a good starting point.
3) US profit margins are showing increasing evidence of peaking. Profitability improvement was one of the key drivers of the 7-year long equity rally. This might be finished, as the profit margin proxy – the difference between corporate pricing and the wage growth – has turned outright negative for the first time since 2008. Buybacks have flattered earnings for a while now, but we would be surprised if these stay a potent support. Buybacks as a share of EBIT are already at ‘07 highs, and credit spreads are widening.
4) Fed tightening is happening very late in the cycle. Typically, the first hike takes place within 12 months of the end of last recession. This time around, we are close to 7 years. Could the Fed appear to be behind the curve, especially if inflation and wage growth picks up? More fundamentally, asset reflation worked during ZIRP to help equities. This could start to unwind.
5) Medium-term Chinese and EM backdrop remains challenging. CNY is back to highs vs EM FX. This could lead to another round of devaluations, possibly in Q1. This would be especially the case if the Fed were to be seen to be falling behind the curve. EM do not typically perform well against a backdrop of a strengthening USD. In addition, EM credit overhang is significant, and NPL upcycle could be just starting.
Importantly, the sector allocation in the event of a down market might not be typical, given that, during the up markets, the leadership was also not orthodox. The bull market was characterised by the leadership of Growth, Defensives and yield. The bear market could see some of the high P/E winners rolling over, not just the weakness in the traditional cycle sensitive names.
In putting the above concerns together, JPM says that "selling any rallies" may be the new "BTFD", adding that "envisages 3 distinct scenarios for stocks, 2 of which are negative."
1) US growth is robust, starting the year strongly, especially as the El Nino effect flatters the seasonal data delivery. Wage growth continues picking up and inflation turns decisively higher as oil price base effects drop out. Fed could start to look as if it is behind the curve, in particular if the projected productivity improvement in the US doesn’t materialise. Markets start to worry about a ’94 type of scenario. The P/E multiples derate, especially in the Growth sectors, those that enjoyed sharp multiple expansion during the past 6 years. EM suffers on the back of a strong USD and potential further CNY devaluation, with rising credit concerns. Equities overall perform poorly.
2) Global growth remains mixed, with no clear rebound in China. NPL upcycle in EM starts in earnest. US profit margins are peaking, with corporate sector consequently turning more cautious. End-cycle dynamics take hold. China undertakes further currency devaluations in an attempt to stabilize its growth, hurting sentiment. In this scenario, global equities are likely to perform poorly, as well.
3) This scenario could be branded a Goldilocks one, not too hot and not too cold. US growth remains robust, Fed is hiking, but can maintain a gradual pace of hikes as productivity growth rebounds. Market leadership broadens to encompass Value sectors, which start outperforming. The Chinese are successful in stabilizing their economy and in averting credit dislocation. Eurozone recovery continues, and more importantly, it is not overshadowed by increasing global uncertainty, as it was last summer. In this scenario, equities perform well, making new cycle highs.
One could argue that over the past 7 years, while most were worrying about deflationary risks, most assets – including credit, fixed income and equities, enjoyed Asset Reflation, with a notable exception of commodities. Asset reflation regime might be giving way to Asset Deflation, where most assets either lose money, at the same time, or are already maxed out in terms of their potential returns.
In short: "Longer term, over the next 12-18 months, we think the risk-reward is turning less favourable; We cut our equity OW to minimal 5% on 30th November."
Good luck to all 17-year-old hedge fund managers and their pet algos.
