Over the next three weeks, the investing world will shift its attention away from the endless chatter of central bankers and concerns about the state of the economy, and instead focus on second quarter earning season, which launched on Friday with results from the three biggest US banks which showed that chronically low volatility is anything but good for trading revenues (as Jamie Dimon made all too clear in a bizarre Friday rant). As previewed last week, and is the norm, we get most of the US numbers first, followed by Europe and then Japan.
And yet, despite expectations for a Q2 S&P500 EPS increase of roughly 7% Y/Y, suggesting solid economic growth, Citi warns that "we may be approaching a cyclical peak." The biggest concern is that recent economic data, especially the "hard" variety, has been anything but good.
In Citi's chart of the week, the bank shows the fall in the US Hard Data Surprise Index which on Friday tumbled to a fresh two-year low. The fall to such low levels occurred due to the near one standard deviation miss in June retail sales. In contrast, US soft data surprises are staging somewhat of a recovery at the moment having bounced off recent lows of -56 to -6. This increase was largely due to positive surprises from both ISM surveys.
In addition to the broader Citi Economic Surprise Index, which is now at mid-2015 levels, the Atlanta Fed Nowcast is also beginning to turn over once again (RHS top).
For now, as Citi's Jeremy Hale notes, forward expectations of earnings for current year and next year in the US are holding up reasonably well compared to previous years (Figure 4, top LHS), however the real question is what happens in Q3/Q4, because as BofA's Michael Hartnett said earlier this week "the most dangerous moment for markets will be when rising rates combine in three or four months’ time with an inflection point in corporate profits. In anticipation of this, we would use the next couple of months to buy volatility, and within fixed income slowly reduce exposure to IG, HY, and EM bonds."
Another concern has emerged. As Citi adds, looking at the driver of these earnings expectations, the commodity rally over the past 12 months has caused analysts to revise higher expectations of forward earnings to relevant sectors, so one would expect oil & gas and basic materials to have large increases in EPS projections. However, given that crude oil continues to make lower highs and lower lows since the start of the year, with increasing non-OPEC production and concerns about the ability of OPEC cuts to sustainably increase the oil price, it’s possible that we begin to see downgrades in these expectations if oil continues to trend lower.
But even if one assumes that somehow future earnings are not dinged as a result of recent oil price weakness, Citi points to something else entirely: the collapse in correlations between earnings and price return since the financial crisis...
... and warns that there are "bigger forces at play" when it comes to future asset prices. Or rather one force: central banks, and specifically "the advent of QE and the ‘easy money’ that has dominated asset markets in this cycle."
The gradual reduction of these purchases and movement to less easy policy from developed market Central Banks potentially leaves asset markets in somewhat of quandary. Our credit colleague Matt King presents a chart which particularly resonates with us, showing asset purchases on a 12 month rolling window vs. risk asset momentum (Figure 5, bottom RHS).
The fit, as Hale admits, "is rather incredible, and ultimately what these charts clearly illustrate is just how important unconventional monetary policies have been for markets in recent years. As such we agree that the removal of CB liquidity, especially if occurring at the same time across the main Central Banks, cannot be ignored."
For risk assets, we are cognizant of recent market experience. In 2015, UST real 10y yields jumped 80bp running into the first Fed hike in December. With a significant lag, equities ended up correcting about 14-15%. In contrast, when real yields rose a similar 80bp in the second half of last year, equities barely noticed (Figure 6 LHS).
One difference is in the data which was weakening sharply in the first episode even before real yields rose (a Fed policy error?). But in the 2016 event, data was strengthening, the global recovery broadening and EPS recovering.
Which brings us back to the chart of the week, and the steep decline in the "hard" data : while until now conventional wisdom has generally assumed that the US economy is broadly rebounding, with conventional wisdom assuming a replay of the 2016 event, Citi cautions that "the fall in the Citi US data change index currently is interesting." One can insert a different word here.
Where does the above leave Citi?
Taking all of this into account, we harbor growing concerns for equity markets and entered into a cross-asset trade, where we positioned for equity market downside, funded via selling volatility in oil markets.
To which Janet Yellen had a response: she pulled at 180 and turned dovish this week, sending global stocks to all time highs, followed by even worse economic data in the US, which in turns sent the S&P to a new all time high as animal spirits got reignited...
... or perhaps it was just more people like Citi, shorting the market then being forced to immediately cover once their narrow stop losses were triggered. As JPM's Prime Broker Service showed last week, the amount of short covering just hit a YTD high.
Although, if that is indeed the catalyst for the latest burst of the "Icarus Rally" higher, it probably won't last. As of this week, the short interest in the SP& is back to level seen just before the last financial crisis...
... which means that what few bears remained in this market have now been flushed.