In his latest note, Citi's Jeremy Hale shows something troubling to all those, such as Bloomberg, who point to yesterday's ISM manufacturing sentiment indicator (while ignoring the rapidly slowing PMI) as indication of more upside left in the economy: according to the Citi cross-asset strategist the bank's NISI Index (news implied sentiment indicator, Figure 1), has plunged sharply into bearish territory in the latest print, to its lowest level in 18 months, since January 2016. According to Hale, as Trump “Optimism” fades, there may have been too much "spirit" priced into the SPX. The latest print in NISI suggests renewed skew towards pessimistic sentiment and thus looking at past correlations to the NISI, Citi warns that the SPX may fall relative to trend for a period on this measure.
It's not just the market's fading euphoria that worries Citi: according to Hale there are 4 other things that worry the bank when it comes to equities, with valuations at the top.
Arguably already rich and perhaps increasingly reliant on earnings to do the “heavy lifting” from here. Breaking down the P/E ratio to P vs. E illustrates how much the market has re-rerated significantly in the last couple of years (Figure 2). Even value stocks are expensive in the US. Additionally, estimates for the current ex-ante ERP are starkly below average historic excess equity returns of +4.7%. In order to even achieve this mean level of excess return, we’d need to see a nominal gdp growth rate of >5.25% (which would be above trend on a 5y, 10y and 30y basis). As such, this would require significant upwards revisions to Citi’s current growth outlook, at a time where Citi Economists say they are close to the cyclical peak in global growth and see increasing downside risks to their forecasts. Combined with undershooting inflation/ declining inflation expectations, this seems even more unrealistic and makes equities appear richer on this basis.
Third, Citi looks at the earnings outlook, and warns that while Q2 and the next two quarters will likely be good, the problem emerges in 2018.
We have no doubts 2017 will indeed be a positive earnings year, but the key is for this to also transpire next year globally. This will require the feed through of higher oil prices (due to the commodity sensitive UK and EM EPS). Whilst Citi currently forecasts higher oil prices, we note that the strong base effects witnessed more recently are slowly rolling off as we move past the oil trough in a one year rolling window. Meanwhile, spot oil prices are trending lower. And earnings surprises have been strong in commodity related sectors. So we need to see earnings strength broaden out heading into 2018.
As Matt King points out, a global shift to tighter monetary policy next year may be quite threatening to risk assets, given how important unconventional monetary policies have been for markets in recent years. His chart, which plots risk asset momentum vs. global central bank asset purchases in a 12 month rolling window, suggests in the event that all major CB’s shrink liquidity together, the implied path may see stocks correct -30% (Figure 3).
As Figure 4 & Figure 5 show, it’s not just equities which are rich in valuation terms. Term premia in long end $ rates remains compressed and close to all-time lows. Citi's credit FV models also indicate that spreads in $IG and $HY are rich, to a magnitude of > 1 std. deviation.
Finally, Hale touches on a chart we posted last week when we discussed whether equities are starting to become irrational. The one chart of interest, which is showed on Figure 6, is a pair-wise correlation
measure of the price action amongs S&P 500 sectors.
We find that as the cycle matures, pair-wise correlations drop. When the cycle turns and stock markets drop, correlation picks up rapidly as investors “sell what they own”. In 2000/2001 and 2006/2007, this correlation indicator fell to around 20% before markets peaked out. Note that we are currently at 30%. Perhaps not quite in the “danger zone” but definitely worth keeping an eye on.
At the end of the day, the positive economic backdrop observable right now is a risk asset positive, in our view. However downside risks are definitely building at a time when valuations are getting more stretched. We feel like it’s too early to fully allocate out of risky assets just yet, and stick to our relatively defensive approach to the reflation trade by being slightly overweight stocks with our preferred adjacent overweight in cash. The latter serves as three things: i) a better portfolio hedge in a base case world which sees rising government bond yields ii) an acknowledgment that valuations are rich, and iii) a tool to be tactical even in medium term GAA portfolios, by having powder to jump into opportunities when they arise.
Citi is not alone: yesterday Goldman also told clients to start leaving risk assets and "go into cash."