… it really depends from which direction the jaws close – through higher rates or via lower equity prices.
That’s what one client told Goldman this week with regard to the “disconnect” between stocks and rates. The ferocious bond rally has driven 10-year yields to their lowest since 2017, while the S&P just closed out its best quarter in a decade.
Here’s a quick look at the “jaws” mentioned above (purple highlight):
As documented here extensively over the past week, getting a “clean” read on the bond rally is quite difficult given the interplay between positioning shifts, repricing tied to the Fed’s ongoing dovish pivot and fundamentals-based moves linked to “legitimate” growth concerns – all three of those factors are inextricably bound up with each other in one sense or another.
Deutsche Bank, for instance, looks at short-term correlations between 10y Treasury yield changes and 10y LIBOR/Treasury swap spread changes in order to get a read on dealer gamma positioning and thereby determine when their hedging flows will amplify market moves.
“When the market rallies, hedging short convexity positions requires receiving fixed rates, which creates additional impetus for declining yields and putting downward pressure on swap spreads”, the bank’s Stuart Sparks writes, adding that “the 30-day correlation of yield changes and spread changes moved rapidly to a positive value following the FOMC.” The bank also saw positive correlations during the Taper Tantrum and in and around last year’s risk-off episodes.
(Deutsche Bank)
In any event, the point is there’s a “signal”/”noise” dynamic going on here that’s difficult to parse and if you want to get down into the weeds on that you can do so here. From a 30,000-foot perspective, Goldman is cutting their year-end forecast for 10-year yields by 20bps to 2.80%.
That’s ostensibly positive for equities with one obvious caveat. “From an investor perspective, stable equity prices coupled with falling interest rates means a wider earnings yield gap and implies a more attractive relative value for stocks assuming the economy does not fall into recession”, Goldman writes.
But Goldman’s clients aren’t just talking about rates and the possibility of an economic recession. They’re also talking about the first YoY decline in corporate profits since 2016 and whether that presages an earnings “recession.” That was a hot topic about a month ago, and you can expect it to start grabbing headlines again as reporting season kicks off.
Read more on earnings recession fears here
“More than 140 firms have reduced 2019 EPS guidance since the start of the year and 67 firms have cut guidance by more than 2%”, Goldman goes on to say, adding that “during the past three months, analysts have cut expectations for full-year 2019 S&P 500 EPS by 4%, nearly four times the usual rate of roughly 1% per quarter.” On the bright side, revision sentiment has rebounded lately to essentially neutral.
(Goldman)
When it comes to Q1, the story remains unchanged. Consensus is looking for a 2% YoY decline, which Goldman notes is “driven by sectors with the highest international revenue exposure: Materials (-18%), Energy (-18%), and Info Tech (-8%).” In other words, it’s driven by companies which are exposed to the synchronized global growth slowdown.
As is customary, Goldman reminds you that the picture one gets from looking at the median S&P company is a bit brighter. To wit:
Although consensus expects strong sales growth of 5% (ex. Financials and Utilities), a 90 bp net margin contraction to 9.9% will result in aggregate year/year EPS growth of negative 2%. However, the median S&P 500 stock is expected to grow EPS by 2%, indicating that a few outsized firms (AAPL, MU, WDC, CVX, XOM, NVDA) are weighing on the aggregate measure. This dichotomy is also present for full-year 2019 EPS growth, with the median firm projected to grow EPS by 6% while the aggregate index grows by just 3%.
That’s all fine and good, but the problem is that market participants (and the media) are notorious for ignoring nuance, which means that if earnings do decline in Q1 and that 1% projected aggregate profit growth in Q2 ends up dipping into negative territory (which it probably will), the “earnings recession” headlines will be plastered all over everyone’s front pages with an accompanying deleterious effect on sentiment.
Throw in lingering worries about the viability of the narrative inherent in consensus baking in a “hockey stick” inflection in Q4 (which will purportedly save the year, EPS growth wise) and you’ve got a recipe for disappointment, especially in the event the US economy decelerates more than folks are expecting.
“Womp, womp”.
