Last November, when one bank after another was releasing its optimistic 2018 market forecast following a stretch of record low, single-digit VIX prints and an S&P500 that refused to even think of dropping, one bank bucked the bullish trend, predicting that the S&P would end 2018 at 2500, about 350 points below the average sellside consensus.
Almost exactly one year ago, we reported that SocGen's equity strategist Roland Kaloyan predicted - correctly- that with bond yields rising, there was effectively no upside left in stocks, which coupled with the prospect of a US economy recession in 2020 would "crimp returns in 2019" Furthermore, in light of what then was a record short in various volatility products, SocGen predicted that vol positioning could "strongly deteriorate the risk reward profile of equity markets."
The S&P 500 has reached our target for the end of this cycle (2,500pts) and is now entering expensive territory. Indeed, on all the metrics, US equities are trading at levels only seen during the late-90s bubble. Since Trump’s election, the US equity market has risen 24%, but only half of this came from earnings growth. The other half has been driven by P/E expansion. According to our calculations, the US equity market is already pricing in potential tax reform. The rise in bond yields and Fed repricing should be headwinds against further US equity rerating.
Kaloyan also warned that upside on the S&P 500 was limited as "the US equity market is already pricing in a rebound in growth and inflation. The rise in bond yields and Fed repricing should be a headwind against further US equity rerating."
One year later, with the S&P just 150 points above his year-end target from last November, and far below the rest of the sellside herd's optimistic consensus, his gloomy assessment was proven correct (there is still over a month left in the year for his bearish forecast to be hit). Furthermore, in a stroke of serendipity, Kaloyan also correctly predicted the February VIXtermination event:
Equity volatility, both realised and implied, has been edging ever lower for quite some time now. Being invested in a simple systematic short VIX future volatility has been strongly rewarding: +290% over the last two years. However, when the tide turns (i.e. VIX spikes), the drawdown can be significant. The quantity of short positioning on VIX open in the market (see right chart) would potentially amplify any spike of the VIX.
Fast forward to today when with the rest of Wall Street once again released price targets that are notably higher than where the S&P currently trades, Kaloyan unveiled SocGen's latest full year forecast, and - not surprisingly - he is just as bearish as he was last year. The report, predictably, begins with a modest victory lap: "This time last year, in our European Equity Strategy 2018 Outlook report, we presented a bearish view for equity markets in 2018. Since then, the MSCI World has lost 9% from its January high, and, while we have identified a handful of factors that could provide some relief to equities in 1H19, longer term, the bear is still here."
The spectre of a US recession in early/mid-2020 would impact equity markets in 2H19.
Looking at US markets in 2019, Kaloyan expects another challenging year for global equities, with "downside potential to global equity indices for the next 12 months, with poor performance expected to be concentrated in 2H as investors discount the next US recession" which the French bank expects will hit in mid-2020. The punchline:
Our end-2019 index targets call for an S&P 500 at 2,400pts, the EuroStoxx 50 at 2,800pts and the Nikkei 225 at 21,400pts.
In a nutshell, in SocGen's view, the challenge will be "to balance the risks of a prolonged economic cycle (resulting from continued central bank liquidity injections) against the opportunities offered by solid companies and undervalued (sometimes oversold) segments." Of the two options, the bank can't help but be more more bearishly inclined.
Here are some more details from SocGen's global projections starting with the US, where Kaloyan expects "a more restrictive monetary policy to push equity valuations lower, while political gridlock and trade tensions will likely be a source of volatility." That said, the equity strategist, has revised his S&P500 target for end-2019 somewhat upward (from 2,000 to 2,4000) as the bank's economics team has ‘postponed’ its US recession call by two quarters.
Factoring in a mild recession in the US in early/mid-2020, our valuation model indicates that the S&P 500 could dip to 2400pts by end-2019 and come out flat in 2020 overall. We would expect the market to bottom some time in 2020.
SocGen is somewhat more optimistic on the eurozone economy, where after a series of disappointing quarters, the end of trade tensions and/or a Brexit deal "could support eurozone equity valuations in early 2019." However, even here upside would likely "be limited as earnings momentum has now entered negative territory." Looking further ahead toward the second half of the year, an ECB rate hike in September would be a source of volatility and push the EUR and the cost of debt higher. In the UK, SocGen is surprisingly upbeat and its base case scenario is for a Brexit deal with the EU, yet even under this favorable scenario, it warns that the subsequent strengthening of the GBP would be a headwind for an FTSE100 index full of exporters.
The "challenging" theme continues in the last region, because whereas Kaloyan expects Asia equities to recover in 2020, "2019 could be another challenging year due to an extended growth slowdown in China, a bear market in tech hardware and a correcting US equity market." That said, a ceasefire in the US-China trade conflict is the upside risk.
The bank's global equity forecasts are summarized below:
Focusing on the US, like last year, Kaloyan believes that the year ahead will be one of risk for US stocks, among which:
1. Risk of political gridlock in the US. As SocGen preciously noted, the results of the US midterm elections have changed the political picture in the US as Congress is now split, wiith the House of Representatives now having a majority of Democrats, while the Senate remains controlled by Republicans. Why is this important:
this could have serious market and economic consequences, such as potentially more frequent government shutdowns, impeachment considerations and general uncertainty. At this late stage in an already lengthy expansion period, uncertainty could be more damaging. The growing US deficit does not leave much room in the event of an economic slowdown.
2. More restrictive US monetary policy. Here too, things are changing: US financial assets benefited from an ultra-accommodative monetary policy for a decade, with Fed funds below the core inflation rate, since 2008. That is now over.
Our scenario assumes three more rate hikes, lifting the Fed funds to 3% by June 2019, putting pressure on equities through three channels:
1) it would push higher the WACC (weighted average cost of capital) and thus lower the valuation of equities (see below);
2) flow wise, investors would reallocate into cash in USD out of other assets (including equities);
3) the Fed funds rise is a typical sign of the end of the cycle (flattening/inversion of yield curve…).
3. US recession in early/mid-2020. The one place where SocGen comes closest to consensus, is its forecast that the US economy looks set to enjoy its last leg of expansion in 2019, making this cycle the longest in history (in June 2019). Meanwhile, the fiscal stimulus has postponed the date of the next US recession, which SocGen now expects in early/mid-2020:
As a consequence, markets should price in the recession a few months ahead of time. This suggests that cyclical concerns could be a major market driver in the 2H19, when GDP growth is already expected to decelerate (1.6% in 3Q19 and 1.1% in 4Q19). The jump in productivity in mid-2018 contained unit labour costs and raised margins, but looking forward, tight labour, rising wage costs and the difficulty of passing on these costs to consumers should narrow margins and reduce incentives for investment and hiring.
4. Avoid the Russell 2000: On a more granular level, while SocGen is not too crazy about either the S&P or the Dow, it hates the Russell, which "would be of the worst performers in the event of a US political gridlock, as US small caps would not benefit from the potentially weaker USD."
Furthermore, whereas mega cap valuations have been within historical parameters, US small caps are now trading at high valuation ratios (trailing P/E ratio of 30.2x vs 20.9x for US large caps) and have near record leverage ratios (net debt to EBITDA of 3.1x vs 1.5x for US large caps).
Thus, US small caps are more at risk from the rising cost of debt (higher rates or higher credit spread – or both) and asset rotation (illiquid segment).
5. S&P 500 to 2,400pts by end-2019. While Kaloyan sees the prospects for the S&P 500 as slightly better than for the Russell, it's not much: the assumption underlying his year-end 2019 target for the S&P 500 of 2,440 points is a decline in sales growth in 2019, and a mild contraction of 5.0% in 2020e.
This decline in activity is consistent with our economists’ forecast of 2.4% GDP growth in 2019e and 0.4% in 2020e, versus +2.9% this year. We then apply margin forecasts to our sales estimates to work out the earnings. Our economists’ team’s chart (see p.13) implies that, at the end of the cycle, profit margins are likely to narrow by c.200bp on average. Hence, we are looking for a margin contraction from 12.0% this year to 10.0% by end-2020.
Applying these sales growth and margin forecasts to current sales and earnings for the S&P results in flat EPS growth in 2019, and a 17% EPS contraction in 2020. Additionally, as a result of Fed action, Kaloyan expects some multiple contraction (chart p.4). Amusingly, the French strategist here notes that "we take into account in our forward P/E assumption the fact that the IBES consensus usually never forecasts an EPS contraction. Indeed, since 1990, the 12-month forward EPS growth has never been below 5% except during the worst of the 2008-09 crisis when it reached -5% (vs -30% looking
at trailing EPS)." As a result, SocGen expects the forward P/E to hit a low of less than 14x by mid-2020, just as the next recession begins according to the bank.
Away from the US, SocGen has 5 key calls on European equity markets: i) Liquidity to dry in the market; ii) Focus on robust earnings; iii) Look for opportunities in trade war casualties; iv): A Brexit deal still likely; v) Hedge against political noise.
Finally, when looking at individual sectors, SocGen writes that while its recession call is not for now, it is already gradually repositioning portfolios for the end of the cycle. SocGen's analysis highlights which sectors appear more at risk and which historically have proven to be more immune to the coming recession. The bank also factors in the impact on sector allocation of last quarter’s changes in the economic, rates and political backdrop. This leads SocGen to its our sector allocation as follows:
- Consumer Staples upgraded from Underweight to Neutral
- Consumer Discretionary switched from Overweight to Underweight
- Information Technology cut from Overweight to Neutral
- Overweight maintained on Healthcare, Oil & Gas, Financials and Basic Industries
- Underweight maintained on Industry, Real Estate, Utilities and Telecoms
In short, another bearish prediction, and while this one seems a little more contained than SocGen's 2018 wildly contrarian forecast released exactly one year ago...
... this time, the bear is now all grown up.