This month's violent market rout, which sent both the S&P500 and Dow to unchanged for the year and pushed most global markets into a bear market, has delivered several other dubious distinctions across asset classes. After seemingly untouchable, many credit spreads (US HY, Euro HG and HY) have widened to their highest levels this year....
... while EM Equities and EM Asian currencies have made new 18-mo lows, and every market - including the Nasdaq, commodities and US Leveraged Loans - has underperformed the trade weighted USD in 2018.
However, as JPMorgan's John Normand observes in his latest weekly note, there is another more "jarring" perspective on this year's cross asset (under)performance: only on two prior occasions - the 1970s stagflation and the global financial crisis - have so many asset classes had negative returns in one year:
"the percentage of asset classes that has generated positive returns this year is only 20%, a share that has never been so low outside of 1970s stagflation episodes and the Global Financial Crisis."
According to JPMorgan there are three likely explanations for this "misery":
- the global economy and US earnings have reached a major turning point;
- the Fed is committing its habitual policy mistake by overtightening; and
- after the pre-Lehman experience with complacency, markets are so paranoid they will overreact late-cycle to even minor changes in fundamentals.
Whatever the reason behind the drop, the violence of the market reaction surprised Normand and his team.
The JPMorgan's strategists note that they have "no argument with the obvious statement" that the most obvious explanation for such steep declines in risky markets this month is that global growth and US earnings are peaking. In fact, as validation they note that global growth, proxied by JPM's global composite PMI reached its zenith around February 2018 and has been decelerating steadily since; EM has slowed on the trade war, and the financial stress triggered by the interaction of Fed tightening, domestic imbalances and some bad policy choices. Europe has also slowed on trade, German-specific production issues and Italian politics; Japan has stumbled temporarily on a series of natural disasters. Meanwhile, the US peaked at 4.1% in Q2 and has slowed to 3.5% in Q3 as the fiscal impulse normalizes and interest-sensitive sectors like housing respond to higher rates. Relatedly, US corporate profits growth was always expected to start slowing in Q3 as the tax boost fades, and they are doing that on cue.
However, what did surprise the JPM strategists, is that slower growth in economies or earnings hasn’t usually been a sufficient condition for turning defensive with investment strategy, "if the run-rate remained around trend."
Indeed, a range of cyclical assets has tended to deliver smaller but still positive returns when growth momentum slows but remains above trend, and haven’t tended to deliver losses until the activity data downshift more materially. With respect to earnings growth, Equities have stopped outperforming Bonds on average about two months after EPS momentum peaks, but have sometimes continued beating fixed income for another year after profits growth started slowing.
As a result, JPMorgan's equity strategist had expected outperformance for another two to three quarters given near-neutral Fed policy, record share buybacks and significant deleveraging by systemic equity investors before earnings season began, a point that JPMorgan's quant Marko Kolanovic had repeatedly pushed, advising clients - so far erroneously - on at least two occasions to buy the dip as a result of what he dubbed fading selling pressure from systematic funds. Unfortunately, as Friday's action demonstrated, that pressure is still notably present.
Which is why Normand notes that "this month markets clearly don’t share our time-limited optimism, perhaps given growing fear that the Fed is committing a policy mistake by tightening to restrictive levels eventually."
So is JPM right, or is the "paranoid" market correct?
Here JPM states that if it is right about the path over the next one to two years "slightly above-trend growth into 2019, restrictive policy from late 2019, possible recession in 2020" does the market needs to start pricing in the endgame now? If not, Normand believes that 2018 looks like the year of overreaction.
Or maybe not: after all, markets are forward looking, and it is natural to discount today a future state of the world, however to JPM, the market is simply too jumpy and is discounting the worst-case scenario too early, instead of "turning progressively over 2018 and 2019 rather than almost simultaneously this year, and only in response to material catalysts."
And even though Normand believes that a Fed rate closer to restrictive plus a much slower pace of earnings growth would be required to justify defensive positioning, the market is clearly paranoid enough to price in the "turn" much sooner than at least JPMorgan's strategists would have expected. They justify their optimistic timing on the market's downward inflection point as follows:
There have been precedents for Equities turning only when the economy enters recession (like around the 2007 recession), which implies a window for owning cyclicals until 2020. There are also examples of stocks turning a year before that growth slump (like around the 2001) recession, which implies cutting cyclicals around the beginning of next year. We have opted for a window in between -- so a possible rotation into defensives around mid-2019 -- because valuations in early October 2018 were far from the levels reached before stocks peaked in March 2000 (S&P500 forward P/E of 16 vs 21 then) and the real Fed funds rates far from restrictive (0% now vs 4% in March 2000). The drop in EPS growth from early to late 2000 was also much sharper than what we anticipate from 2018 to 2019. (By late 2000, EPS growth was negative).
Rationally justified as JPM's timing may have been, the bank concedes that the risk has always been that markets would turn earlier, because investors' mindset has changed this cycle, and especially in a time when central banks are pulling back on the training wheels, traders have become increasingly paranoid:
If complacency is one of the words most associated with the pre-Lehman years – even Queen Elizabeth asked publicly afterwards, "Why did no one see this coming?” – then paranoia may be the one most tied to what remains of this cycle. The second-longest expansion in post-war history and the slowest Fed tightening cycle in three decades has given investors plenty of time to build exposures, but also to study the anatomy of turning points and to contemplate the exit constraints from lower market liquidity.
To JPM this may explain why so many defensive trades across Equities and FICC are delivering recently, even though the odds of a recession as calculated by JPMorgan over the next year - 30% on JPM's probit model - are well below the threshold usually associated with durable outperformance of these strategies. That, or JPM's recession model is fatally flawed.
Normand's parting words: we were wrong about the turn, but we are not wrong enough yet to throw in the towel on a "semi" optimistic outlook:
We are not yet willing to run the year of tracking error implied by holding broadly defensive exposure until the global economy weakens materially, so continue to favor the semi-cyclical strategy instead.
In other words, like many other banks, JPM still needs retail investors and institutional clients - those who are reading its research reports - to keep buying what JPMorgan has to sell. We are "confident" that JPM will be honest enough to tell its clients when it sincerely believes that the bull market is over, even as it keeps on doubling down on its BTFD calls all the way down.