When the market last heard from Marko Kolanovic, the JPMorgan quant was busy detailing an “unprecedented” divergence between U.S. equities and the rest of the world.
Specifically, he noted that price momentum was positive for U.S. equities and negative for European stocks and EM “across all relevant lookback windows.”
That, he observed, “has never happened before.”
Given the rather stark juxtaposition, Marko suggested that “something will have to give”.
It’s not difficult to explain what accounts for the divergent fortunes of U.S. equities and their global counterparts. 2018 has been defined by U.S. stocks’ ability to rise despite international developments. That bulletproof character is ironically attributable to the very same policies that have rattled risk sentiment outside the U.S. U.S. fiscal policy catalyzed a buyback binge, bolstered corporate bottom lines, and helped prolong the economic expansion, but a consequence of that same fiscal policy is a more hawkish Fed and a stronger dollar. The stronger the dollar, the more pressure on EM.
Meanwhile, the trade tensions have weighed on the outlook for global growth, and as a consequence, the divergence between the U.S. economy and the rest of the world has widened, making U.S. assets look even more attractive compared to their international counterparts and thereby exacerbating the performance disparity.
Finally, protectionism raises the specter of higher consumer prices at home, which in turn makes the Fed predisposed to hawkishness in the interest of guarding against an inflation overshoot.
Implicit in all of that is the notion that the dollar needs to take a breather in order for the rest of the world to catch up with the U.S. That breather came in mid-August and did indeed catalyze a fleeting bit of respite for a beleaguered EM complex that was struggling to avert disaster following the collapse of the Turkish lira.
To be sure, the reprieve was brief. Soon enough, the Argentine peso plunged anew and ZAR came under pressure as data showed South Africa fell into a recession for the first time since 2009 last quarter.
In his August note, Kolanovic said that the “unprecedented” divergence noted above would resolve itself in one of two ways:
- ‘Risk on, USD down’ outcome with EM and value assets staging a rally and USD selling off, while US stocks continue going higher (but lagging).
- Alternatively, we could see a “Risk off, USD up” convergence, with US markets selling off and catching up with the poor performance of Europe and EM assets, e.g. driven by a continuation of the trade war and further USD strength (for now we will ignore a spectrum of ‘in-between’ outcomes).
It’s still too early know which of those outcomes will ultimately play out and thereby whether U.S. stocks will catch down to the rest of the world’s reality or whether the world will catch up to U.S. equity euphoria.
Well on Tuesday, Kolanovic is back with an asset allocation update and JPMorgan is sticking with an overweight equities call versus fixed income. And yes, they are still inclined to be bullish on emerging markets in the face of escalating trade tensions. Here’s Marko:
Despite trade headwinds, our asset allocation remains OW Equities vs. Fixed Income, with an increasing contrarian tilt towards EM, value and non-USD assets. The main premise is that the global growth cycle is intact, and the divergence between US and international fundamentals, investor sentiment and asset performance reached extremes. We gradually trim exposure to US stocks and dollar assets, as they acted as a trade war “safe haven” so far, but investors may ultimately rotate into more attractive foreign assets if trade concerns ease. In case of a full-blown trade war (the probability of which marginally increased with the new batch of tariffs), US corporate earnings will be negatively impacted, and multiples may come under pressure from political instability in Washington. We added to assets such as EM equities and FX, Metals and Mining, Autos, Semis, China tech, and LatAm equites that already took the brunt of trade worries.
Again, this is a lengthy asset allocation update (as distinct from Marko’s QDS strat pieces), and the analysis spans multiple asset classes and covers a variety of cross-asset themes.
But sticking with the general strategy section, Kolanovic warns that the “sugar high” from U.S. fiscal stimulus is likely to wear off in the months ahead.
“The large US fiscal boost this year, as well as the delayed positive impact of weak USD and low rates from last year created a ‘sugar high’ for US assets this year”, Marko writes, adding that “this is likely to wear off in the coming quarters as y/y comparisons in US economic and earnings growth are bound to decline, and the impact of higher USD and rates kicks in.”
Right. And while recent data (e.g., ISM, the August jobs report, small business sentiment) clearly suggests the boost from late-cycle stimulus is still rippling through the economy, everyone with any sense knows that even if the fillip proves to be some semblance of sustainable, the current pace of activity on several metrics most assuredly is not.
U.S. markets, Marko writes, acted in August “as if the deficit funded stimulus can continue in perpetuity and potential tariffs may not affect US companies and consumers.”
Obviously, that’s not realistic and you needn’t be bearish (Marko isn’t) to know how unrealistic it is. Here’s a snapshot of performance across assets in August versus YTD:
Looking across JPMorgan’s allocation, the following excerpts shed further light on their rationale for equities, EM, credit, and commodities, respectively:
US Q2 earnings were very strong (+25% y/y) with the highest number of beats in nearly 10 years. Europe and Japan earnings were above-average, but less impressive. We expect the strength of US earnings to continue. Looking further out, earnings growth should moderate to ~10% as benefits from tax reform wear off. The record amount of corporate buybacks should continue to support US earnings and hence equities. We thus remain OW US equities, but use the current strength to trim down the US and start to build larger exposure in EM equities which are trading at distressed levels. So far, US equities have largely ignored the possibility of tariffs on all China trade. As half of the trade with China now may be subject to tariffs, there is an increasing probability of corporate earnings being revised lower, dampening the sentiment towards US stocks.
While EM fundamentals have deteriorated this year due to macro developments and country idiosyncratic issues, we believe asset prices have already undershot fundamentals. For example, a simple valuation model based on regressing EM asset returns vs EM PMI, indicates EM valuation discounts of up to 10%.
We remain UW credit on heavier seasonal supply in the fall, continued liquidity tightening and elevated macro volatility.
We remain OW commodities on the positive economic outlook, short speculative positioning and sensitivity to USD that might be close to peaking.
So what could go wrong with an asset allocation that is, on balance, pro-risk? Well, Trump, for one thing.
“Global trade war, and more broadly Trump actions, remain the biggest headwind for US and global markets”, Marko continues, before noting that he still generally believes Washington and Beijing will come to some kind of negotiated agreement before things spiral completely out of control.
On Monday evening and also on Tuesday, Trump and his surrogates variously suggested that the administration will view any retaliation from China to the latest round of tariffs as a justification for slapping duties on another $267 billion in Chinese goods, effectively taking the total amount of imports taxed to $500 billion, or, more simply, the entirety of Chinese exports to America.
Kolanovic thinks that’s unlikely. “Applying the tariffs to the full amount of China trade would cause a disproportionally negative impact on US equities, and as such would be an irrational move, and is unlikely to be implemented,” he says.
In addition to the risk from trade, Marko flags “political tail risks in Washington” as a potential stumbling block. Perhaps more notably, Kolanovic warns that “a failure of the Fed to recognize potential [adverse] developments” on trade and domestic politics could be a problem.
You’ll recall that back in July, Marko suggested it might be time for the Fed to take a pause, considering the increasingly fraught backdrop in EM.
For now, it doesn’t appear that Jerome Powell is inclined to listen.