BofAML is out on Thursday calling the euphoria in the US equity market what it is: “wishful thinking.”
Besides the rather obvious fact that…
- valuations are stretched to the proverbial breaking point,
and besides the fact that…
- if we can indeed begin to take central banks seriously when it comes to their intentions to normalize policy (as evidenced in the ECB’s removal of the reference to further rate cuts and reports that even the BoJ is contemplating an exit strategy), then it’s reasonable to suggest that the artificial vol suppression behind the dynamics driving risk assets to nosebleed levels is about to fade,
….the myriad geopolitical land mines littering the investment landscape should themselves be enough to warrant more caution than prices seem to reflect.
And while BofAML touches on those points as well as the possible impact of China’s ongoing efforts to tighten policy, the bank also notes that measures of business and consumer confidence are at odds with what they’re hearing from CFOs.
Read more below on why you should probably curb your enthusiasm…
No doubt, the fact that US business and consumer confidence has so far held onto the post-election surge (Figure 5 and 6), notwithstanding the lack of progress on tax reform, is encouraging many equity investors to discount the importance of tax reform for the US economic outlook.
We would caution against taking too much comfort from these confidence surveys. At a gathering of 100 CFOs in Dallas last week that this strategist was invited to address, only 5 participants believed tax reform will get done this year but 90 people thought the US economy could be in a recession in less than 2 years without a tax reform. This is consistent with what we are hearing from many companies that are reluctant to make major hiring or capital expenditure decisions without clarity on tax reform. In this sense, the uncertainty around tax reform itself is possibly dampening US growth.
This wait-and-see attitude among US companies is starting to show up in the data. Core durable goods orders have been flat in the past three months (Figure 7) while the three month moving average of hiring slowed in May to just 120K, the most sluggish pace since the Eurozone crisis in 2012 (Figure 8). Like the consensus, our US economics team is still forecasting a vigorous rebound of 3% GDP growth in Q2. However, we don’t think the market has priced in adequately the downside risk to growth associated with the heightened uncertainty around tax reform and political standoff.
Asia and Europe did better than the US in Q1. Indeed, US corporate profit data shows that while profits of domestic non-financials were down 8% (y/y), overseas profits were up 24% (Figure 9). Can the rest of the world continue to offset a slowdown in the US?
Chinese growth has recently begun to decelerate (Chart 10), in response to tightened financial conditions brought about by the introduction of tougher credit regulations in March (especially in off-balance sheet lending activities). Our China economics team believes that China is only at the beginning of financial deleveraging and expects it to continue at least until the 19th Communist Party Congress in the fall. While they see the risk of widespread financial instability as limited for now, they do expect growth to slow in the coming quarters. The rest of Asia will not be able to escape the impact of the Chinese slowdown. Taiwanese export orders (seasonally adjusted) are already down two months in a row.
Recovery in Europe has been stronger and more balanced than elsewhere (Chart 11). However, our European Economics Team expects Eurozone GDP growth to moderate in H2. Eurozone credit conditions remain quite tight (Chart 12) and credit recovery already showed signs of stalling in the April data.
Around the globe, political risks are flaring up:
- New corruption charges levied against President Temer in Brazil are threatening to impede the passage of the urgently needed social security reform.
- North Korea successfully launched three test missiles over the past month, dramatically escalating tension in the region.
- The decision by Saudi Arabia and Egypt this week to break off diplomatic ties with Qatar has increased the risk of direct confrontation between Iran and moderate Sunni countries.
- Italy could be holding early elections in September and the populist Five Stars Party is currently leading in most of the opinion polls.
- The UK will soon begin the Brexit negotiations with Brussels that are unlikely to be smooth.
With US companies seemingly reluctant to make major decisions on hiring and investment ahead of tax reform, with tightened financial conditions starting to bite into Chinese domestic demand, and with an escalation of political risks across the globe, it seems to us that the equity market may be too complacent about downside risk to global growth.