There’s a battle brewin’ over at Citi that pits the bank’s equity strategists against Matt King’s mighty credit team.
Regular readers will recall that we’ve spent a considerable amount of time outlining the cautious view espoused by King, Hans Lorenzen, and Joseph Faith. You can read those posts below:
- A Psychedelic Trip Through Surreal Markets – Hans Is Bringin’ The Shrooms
- You’re Going To Have To Buy $1 Trillion In Securities Next Year. Are You Ready?
- There Is No Exit
Their message has been consistent: when central banks pull back and the liquidity flow dries up, risk assets of all stripes will be in jeopardy.
It’s not hard to see why that argument makes a lot of sense.
All you have to do is think about supply-demand dynamics (if too much money chasing scarce assets leads to higher prices, then less money chasing assets that are less scarce leads to the opposite) or, if that’s too much to ask, just plot the central bank liquidity impulse against equities and credit spreads (right pane below):
But Citi’s Robert Buckland and team (that would be the equities side of the desk) aren’t buyin’ what Matt King and his posse are sellin’.
Below, read the arguments on both sides (excerpted from Citi’s latest Global Asset Allocation piece) and decide for yourself who’s correct and who isn’t…
Synchronised Global Recovery vs. CB Withdrawal
The cornerstone of the equity argument presented by Robert Buckland and team revolves around the idea that we are seeing “synchronized growth” – i.e. a strong economic backdrop feeding positive EPS growth in all major regions. This is indeed a relatively rare thing, with only seven years since 1990 satisfying their conditions. They show how equities are the net beneficiary of such a backdrop, with stocks historically doing well and, crucially, also outperforming the returns seen in non-synchronised years (Figure 4, bottom).
It’s hard to argue against the link between the economic backdrop and EPS, and on the relationship shown on the top RHS of Figure 4, the Citi nominal growth forecast of 3.9% for the US, would imply EPS growth of around 5-10% for 2017.
We have no doubts 2017 will indeed be a positive earnings year, but the key is for this to also transpire next year. As we have said before, with earnings being subpar in recent years and markets re-rating considerably, arguably opening a gap between the P and the E (Figure 4, top LHS), earnings need to do the heavy lifting.
This is where perhaps one of the caveats to their story lies. One of the conditions in their synchronised growth analysis is higher oil prices (due to the commodity sensitive UK and EM EPS). Whilst oil prices are forecast higher, we note that the strong base effects witnessed more recently are slowly rolling off as we move past the oil trough in a one year rolling window. Meanwhile, spot oil prices are falling on trend. And earnings surprises have been strong in commodity related sectors. So we need to see earnings strength broaden out heading into 2018.
The other observation is that these “synchronised growth” years tend to occur late into the cycle i.e. the years before 2001 and 2007. So whilst markets do ok in the year in question, perhaps synchronised growth is actually a late-cycle indicator warranting more caution the following year or so?
Finally, the ‘goldilocks’ setting prevalent in our economists’ forecasts – i.e. better growth but subdued inflation – historically supports equity markets. But one key difference to historic goldilocks episodes may be that even in the light of low-flation, Central Banks are seen to step away from maximum accommodation over the GAA horizon.
This is where our credit colleagues under Matt King come in with their argument. In their latest presentation they present the charts re-created in Figure 5. On the LHS chart the split between global central bank asset purchases in a 12 month rolling window is shown. On the RHS, the same series is then compared to risk asset momentum. The fit is rather incredible, confirming, as we have written about often, that central bank actions/QE have been a prominent driver of markets in the current cycle.
With the Fed continuing on its hiking path and now also close to reducing its balance sheet, the ECB moving towards taper discussions too, markets eyeing when the BoJ might do the same and even the BoE turning hawkish, the implied path of equities and credit on these charts looks scary.
Of course there are caveats to this story too. For one, these moves will (hopefully) be well communicated as the taper tantrum will loom large in Central Bankers memories. And the ECB might avoid going down the hard taper road and start fudging the capital key instead . And EM reserve changes could easily counter the G10 trends. EMFX has been strong, especially in CEEMEA and Latam, so reserves flows into $ assets will be increasing.
As a result, the -30% to stocks and +100bp to IG credit implied by Matt’s charts could well be overstated. Indeed we note that the US IG credit forecast from his team is ‘only’ ~27bp wider.
But 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.
While this debate will sort itself out over the long run, there may be only one way to settle it in the near term…