Goldman's Q&A On "Where We Go From Here For Equities" (And Why The Peripheral Europe Party Is Over)
Earlier today, it was BNP which, after launching the first rumors that a QE from the ECB is imminent (it isn't as Mario Draghi himself explained back in November 2011, but the ECB sure knows how to jawbone idiots to duration death) back in November, admitted it really had no idea what it was talking about and said "there’s now a meaningful risk ECB’s policy May meeting disappoints investors betting on fresh easing" adding that it saw a near-term chance of profit-taking before euro-area April inflation data. Its conclusion - unwind trades that have benefited from expectations of ECB QE such as the wave of unquestionable lunacy lifting each and every Spanish, Italian and Greek bond, all of which are simply trading where they are on hopes the ECB will be the dumbest money buyer left standing.
Moments ago it was Goldman's turn. In a rhetorical self-QE released by its strategist Peter Oppenheimer, discussing recent changes to long-running market trends, among which the crash in momo stocks, and the EM to DM inversion, the punchline was the most important. To wit: "We see less scope for this peripheral index... Peripheral spreads may narrow further, but more now via higher bund yields. After all, 5-year Spanish and Italian bond yields have converged to the same levels as the US. We still like selected parts of the peripheral markets, particularly the banks, but would prefer to express this via single names than via index overweights... the drivers of returns may have shifted away from some areas such as US growth and European periphery towards more of a cyclical bias across markets, with a particular focus on exposure to a DM macro recovery."
In other words, while the momentum bubble may have popped (if still has a loooooong way to go before it deflates) the European peripheral bubble is about to go pop as well. For all those who just bought Spanish 10 Years at a record low yield (yes, record low) yesterday, our condolences. Then again, it's only other people's money.
For everything else, here is the full Oppenheimer note:
Taking Stock: Rally Driving
The year has so far been a challenging one for many investors. The uncertainty regarding macro data and EM weakness in Q1 has transitioned into a period of rapid momentum damage in Q2. In this Taking Stock Q&A, we describe our take on recent events and where we go from here for equities around the world.
Q: What has this momentum reversal been about?
A: The damage has been widespread, but, as we described in Strategy Matters: Momentum, rotation and the gradual grind higher, April10, 2014, the reversal in performance seen across most markets has been swift, but has manifest itself differently across markets. To us, this suggests that the damage is first and foremost about positioning as opposed to a dramatic change of fundamental expectations.
In the US, it has mainly taken the form of a sharp reversal of the growth/value trade, mainly reflecting the damage in performance to the technology and biotech sectors, in particular. Asia has also seen a reversal of growth/value.
But in other parts of the world, growth/value indices have hardly budged. Europe and Japan are both good examples as the charts below show.
US has seen a sharp Growth vs. Value reversal recently, while Europe and Japan have seen very little change.
Even in the US, the tech sector underperformance has not been very aggressive, but the concentration of positions has been an important ingredient. As David Kostin and team in the US have shown with their hedge fund VIP basket - a basket of heavily concentrated hedge fund positions - the pain in recent weeks has been very significant but has already started to reverse.
Concentrated hedge fund positions have seen a sharp reversal in performance but have begun to rebound
Of course, the damage has not been confined to the US. Japan, for example, has been one of the worst performers YTD (-11% in local currency) having previously led the global rally in 2013. In Europe’s case, the performance damage has reflected the rebound of many EM related stocks (previous laggards) and modest underperformance of the peripheral markets (previous leaders).
EM-exposed stocks have rebounded recently, while periphery stocks have underperformed
In EM, meanwhile, there has been a bounce across the board with prior laggards, such as Turkey, Korea and Mexico as well as China and India, outperforming.
All of this suggests that there has not been a very common theme across the markets during the correction. If it had been about a wholesale shift in investor views about, say growth, one would have expected a more consistent pattern of returns across markets with cyclicals underperforming defensives. As yet, this has not really happened in any consistent or uniform way. As the exhibit below shows, the global averages of cyclicals relative to defensives has not demonstrated any significant reversal, and this is true when we dissect the markets beneath the average too.
World Cyclicals vs. defensives
Q: Maybe not all the returns have been consistent, but one thing that is clear has been the bounce in EM equity markets, as well as other EM assets. Is this sustainable?
A: In our view the general pattern of DM outperformance relative to EM in equities will re assert itself as economic data improves.
A bounce has occurred both in EM markets directly – and the stocks with high EM exposure within the DM markets have also bounced, particularly in Europe (see exhibits below).
But this does not necessarily mark a major turn and indeed some of the strength seems to be fading already. In both cases (direct EM exposure and EM exposure in Europe), the rebound has been very modest relative to the underperformance of the last couple of years.
The rebound in EM is modest relative to past underperformance
While there may not be an imminent setback for EM assets, the better performance in recent weeks has shifted some EM asset valuations, notably FX and rates, more away from equilibrium rather than towards it, particularly in deficit countries like Brazil and Turkey. The rally has also brought equity risk premia down from very high level, leaving equities exposed to any disappointment over a cyclical recovery in China growth or from low US rates (see EM Weekly: A higher bar for the EM rally to extend, April 17, 2014). Also given that the rally was probably triggered by China stimulus and US rates being restrained, and has mainly benefited commodities and banks, these drivers may be fading as our economists see upside risks to rate expectations and the latest batch of China data has not surprised to the upside. That said, we continue to think that differentiation within EM is likely to be a major factor, with some countries with improved fundamentals (such as Indonesia and India) being less vulnerable to setbacks than many others.
Q: So what is your expectation about market direction generally from here?
A: We continue to believe that equity markets will gradually grind higher. The macro backdrop remains supportive. We believe that global growth will continue to pick up through the second quarter and that interest rates will remain generally lower for longer than the market is pricing. Our April Advanced GLI came in at 3.5%yoy, down from last month’s reading of 3.6%yoy, but momentum increased to 0.27%mom from 0.20%mom last month. The reading further supports recent signals of a positive turn in acceleration after six months of slowing growth, and locates the global cycle back in the ‘Expansion’ phase – a part of the cycle that tends to be supportive for equities. Similarly, our March US current activity indicator stands at 3.3%, up from 2.0% in February - broadly in line with our expectation for a rebound from the weather hit of recent months. While Japan's growth is likely to fall sharply into Q2 due to the consumption tax impact, we expect more policy easing later in the year. Our economists also expect China growth to pick up from around 5% to 7.3% this year as the mix of domestic easing and an improving external environment alleviates some of the extraordinary weakness that marked the start of this year.
These observations are also at odds with the interpretation that the hit to markets in recent weeks has been about a shift in macro views. On the corporate side too, we remain of the view that results are about to improve. We expect earnings to rise this year by between 8% in the US to over 20% in Japan with Europe and Asia roughly in between. In all cases except the US, we expect an improvement in margins as well as top-line growth. It is also notable that while earnings revisions have been very negative in all regions (with the exception of Japan) over recent months, there is some evidence that they are just starting to get less negative in terms of balance between upgrades and downgrades.
CY14E earnings sentiment for MSCI AC World has started to turn, although still negative
Q: So has anything really changed?
A: Not really; we continue to believe that while valuations are unlikely to expand as they have done since the trough on 2009, equities can move higher alongside improved earnings and dividends. If anything, the risk to this view is that an economic recovery drives investors further up the risk curve and forces valuations higher still resulting in stronger markets shorter term, but lower returns subsequently. But on balance, we expect a more moderate but steady rise in equities driven by improving macro fundamentals and profits with the highest returns in Japan followed by Europe, Asia and the US.
Q: What about sectors and themes?
A: We do think that some of the leadership of recent months in the markets will have shifted in favour of value, but largely as a result of exposure to a DM recovery more than anything else. From a leadership perspective, David Kostin and team have argued that similar momentum reversals in the US are typically followed by a change in leadership – in particular towards value (please see US Weekly Kickstart: The stock market, but not momentum stocks, will likely recover during the next few months, April 11, 2014) – but in the US, the value indices are quite heavily dominated by cyclicals (in particular Oil & Gas 14%, Technology 13% and Industrial Goods & Services 11%). Our US strategists still like their operational leverage basket (GSTHOPHI).
Elsewhere, we generally have a cyclical bias too. In the case of Japan, Kathy Matsui and team have kept their sector views largely unchanged, but have increased allocations more toward exporters in anticipation of a reacceleration in global growth. They also continue to focus on domestic demand beneficiaries – a theme before the recent momentum hit – as they see the pause in domestic demand to be temporary; also on the growth theme, they remain focused on industries with strong earnings momentum and capex beneficiaries.
In Asia, Tim Moe and team also have a more cyclical stance (see Asia Pacific 2Q Views: Rebound; favour a three-part cyclical cocktail, March 31, 2014). They favour North Asia including Korea and Taiwan to recoup some of its recent underperformance vs. South Asia as DM growth/rate dynamics begin to shift to North Asia’s favour. They also like China for the cyclical rebound prospects. In South Asia, they prefer India, which is also reflecting its recovering growth. Their recent upgrades of insurance and capital goods and downgrades of Malaysia to underweight (alongside Australia, HK, and Thailand) also reflect our pro-cyclical bias.
In Europe, the recent rotation has largely been away from the periphery towards more EM exposed areas of the market. The peripheral index leadership may have shifted – at least there are some good macro and valuation-led reasons to suggest this. Much of the peripheral outperformance over the past several months was a direct reflection of falling risk premia and narrowing bond spreads.
The outperformance in the periphery over the past few months was driven largely by falling risk premia and narrowing bond yields
We see less scope for this peripheral index outperformance to continue. German bunds are expensive and our bond strategists argue for 10-year bund yields to rise to 2% this quarter. Peripheral spreads may narrow further, but more now via higher bund yields. After all, 5-year Spanish and Italian bond yields have converged to the same levels as the US. We still like selected parts of the peripheral markets, particularly the banks, but would prefer to express this via single names than via index overweights. On EM exposures, alongside our EM strategists, we continue to see the rebound as mainly tactical. In Europe, we have made some moves to moderate our EM underweights -raising luxury goods to an overweight to reflect improved valuations, for example - or because of general cyclical exposure to global growth -as in the case of Industrial goods and services where we are now neutral. That said, we continue to have a fair degree of underweight exposure in EM exposed parts of the market. We remain underweight industrial areas like capital goods, chemicals and basic resources that are likely to continue to suffer from weakness in capex demand from EM infrastructure and commodity end markets. Elsewhere, consumer exposed staples like food remain expensive, in our view, and we continue to be underweight. We continue to focus on the DAX and our DM cyclical exposure basket GSSTDMGR.
All in all, we would describe the rotation as being more a reflection of damage to concentrated positioning than a reflection of a change in market views. As such, the drivers of returns may have shifted away from some areas such as US growth and European periphery towards more of a cyclical bias across markets, with a particular focus on exposure to a DM macro recovery. We believe the market set back in DM has been temporary and expect equities overall to continue to outperform bonds and to resume their rally.
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