The Bull That Just Wouldn’t Die

“What doesn’t kill the bull makes it stronger”, Bloomberg’s Lu Wang wrote Friday, in a piece that attempts to capture the market zeitgeist as we flip the calendar to 2020.

Several of Wall Street’s year-ahead outlook pieces revolve around the notion that 2018/2019 did not mark the end of the cycle, but simply represented another rough patch from which equities will invariably recover, similar to stumbles around the European debt crisis and the 2015/2016 experience, when China devalued the yuan and oil prices plunged, resulting, eventually, in the “Shanghai Accord”.

After each scare, the market found its footing and subsequently pushed higher, this time on the back of an epochal, coordinated dovish shift from central banks.

2019’s easing impulse (measured by the net number of rate cuts) is the strongest in years, helping to explain how it is that risk assets have managed to power ahead in the face of what seemed, until this week anyway, to be intractable geopolitical tumult.

Of course, the gains haven’t been the result of earnings growth. Indeed, virtually all of stocks’ rise in 2019 is attributable to multiple expansion. In the US, earnings growth turned negative in the third quarter, and while profits are expected to rebound, the halcyon days ushered in by the Trump tax cuts aren’t coming back. Tariff relief aside, there are plenty of reasons to expect margin pressure will build for US corporates in 2020.

Make no mistake about it, this is not just a US phenomenon.

Still, this week brought “clarity” (if that’s the right word) on a number of fronts, from trade to Brexit to the Fed’s unanimous messaging to how ECB press conferences will sound under Christine Lagarde, self-described “wise owl“.

Between the clearing of macro clouds and the assumption that dozens of rate cuts around the globe are set to start working their way through and manifesting in better economic outcomes, analysts are keen to suggest the aging bull can run further still, having narrowly defied death again this time last year (if only on a technical definition).

JPMorgan’s Marko Kolanovic adopted this line of reasoning in his year-ahead outlook. For Marko, the various bouts of geopolitical and market turmoil and the accompanying slowdown in global growth (concentrated in manufacturing) does not mark the end of the cycle.

In a note out this week, Kolanovic described the last 18 months as “a reset similar to crises that occurred every 3 years after 2008”. He cited 2011/2012 (i.e., the European debt crisis), 2015/2016 (i.e., the mini-industrial recession that accompanied EM turmoil, the yuan devaluation and the oil price collapse) and, now, 2018/2019.

Read more: Marko Kolanovic Delivers 2020 Outlook, Sees Higher Stocks, Better Macro

A look at JPMorgan’s full global asset allocation finds Kolanovic, Nikolaos Panigirtzoglou and John Normand delving further into things.

The bank is OW equities, “modestly” OW commodities and UW bonds, with a focus on high quality IG corporates, which JPMorgan says are “more vulnerable to a potentially big downshift in bond fund demand”.

“Our risk-on stance is supported by the improvement in growth indicators over the past couple of months”, the bank writes, citing a “bottoming out of global manufacturing PMIs and the strength of US labor markets” as factors which are “lowering US recession risks and boosting confidence to the mid-cycle adjustment thesis”.

That thesis is, of course, something the Fed has been keen to defend against charges policymakers will be forced to resort to additional rate cuts in the first half of 2020. To be clear, anything beyond the three cuts delivered would be virtually impossible to spin as an “adjustment”.

JPMorgan goes on to write the following, bringing in a comparison to a previous instance of Fed insurance cuts:

If this thesis proves correct and a US recession is averted, the current mid-cycle adjustment will be the third in the current expansion that started ten years ago. The previous two midcycle adjustments took place during 2011/2012 and 2015/2016. However, these two previous mid-cycle adjustments were different in nature to the current one. The 2011/2012 was caused by the euro debt crisis and the 2015/2016 by a commodity shock that caused a sharp dollar appreciation and forced China to devalue its currency twice. The current mid-cycle adjustment has instead been driven by a combination of previous Fed overtightening and trade wars. Both of these causes are improving as the Fed has been quick in reversing its previous overtightening in both the rate and the reserve space and as trade wars appear to be de-escalating as we head into the 2020 US presidential election year. From a historical perspective, the closer to the current midcycle adjustment was perhaps the 1995/1996 one. Similar to now, the cause was the Fed’s overtightening during 1994 which had created a mid-cycle slowdown in 1995 during which the Fed was forced to cut rates three times from the summer of 1995 to January 1996.

So, what happened to stocks, bonds and (for example) manufacturing during the 1995/1996 mid-cycle slowdown?

Well, the bank is glad that you asked, but before getting to the answer, they note that ” the macro and market trajectory over the past six months has been similar to the mid-cycle adjustment of 1995″ in at least one respect – namely that the manufacturing sector suffered a “severe” slowdown, but ultimately bottomed around the same time the Fed delivered the final insurance cut.

“A similar trajectory appears to be playing out at the moment, with current signs of bottoming out in US and global manufacturing coinciding with the last Fed insurance rate cut at the end of October”, the bank says.

(JPMorgan)

As for markets, the 1995/1996 experience indicates that we should expect around 5% upside for US equities through mid-2020, sharply higher 10-year yields and a steeper curve.

(JPMorgan)

There are some caveats, of course. For instance, the bank notes that “this assumes the US macro picture remains consistent with a mid-cycle adjustment” which entails ongoing resilience in the labor market and consumer spending, as well as “continued recovery in manufacturing similar to that seen in 1996”.

On the labor market front, things are going well. The November jobs report was obviously a blockbuster, but retail sales data out Friday suggested the rise in equities to new records and the concurrent rebound in consumer sentiment did not translate into more spending last month.

At the same time, ISM manufacturing remains mired in what is now a four-month downturn, although the Markit gauge tells an entirely different story.

For JPMorgan, it’s not just the macro backdrop that argues for higher equities and higher long-end yields in the new year.

“The market trajectory implied by the 1995/1996 experience, i.e. of higher equity prices and bear steepening of core government yield curves, is in our opinion supported by flow arguments also”, the bank says, on the way to describing 2019 as “a very unusual year in terms of the behavior of retail investors, with close to record high bond fund buying and record high equity fund selling”.

(JPMorgan)

While admitting that their call on flows “faces major challenges”, the bank argues that if you go by history, “such fund flow extremes tend to reverse in the following year, pointing to a dramatic change [in 2020] with a reversal of this year’s equity fund selling and a big downshift in bond fund buying”.

JPMorgan’s arguments are, in a kind of general sense, indicative of consensus. The overarching narrative right now is that with some macro headwinds (e.g., trade and Brexit) set to abate and with the Fed having reversed course, there’s little to stop equities from moving higher and DM yields from marching up, led by breakevens, as inflation expectations rebound in line with a rosier economic outlook.

It sounds like a compelling thesis, and it might well turn out to be accurate. After all, anyone betting on the death of the longest bull in history has been gored since the crisis.

But, you know what they say about the “best laid plans of mice and men”…

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