Late 2018 equity markets reached our 15-20% drawdown target. But liquidity and macro indicators have deteriorated. We see a higher probability for an earnings recession and stick to a defensive view but it is a tougher call than our 2018 bearishness.

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Since mid-May 2018, we have held the view that the stock markets and economies would follow a roadmap similar to 2015-16. After a vicious December, global equity markets reached our initial target of a 15-20% drawdown from the peak, a drop in line with the 2015-16 experience. On the macro side, however, we find that the comparison with 2015-16 no longer fully holds true. We have already indicated in previous issues of Nordea View that there are several negative differences compared with that period, which could mean a more negative stock market scenario this time. Currently, we are even more worried about those differences; so, we are not yet willing to neutralise our underweight equity and corporate bond positions. We admit that the call is much harder to make now that markets have temporarily corrected to forward P/E levels that could be viewed as fair on a longer time horizon. However, profit-neutral multiples, such as EV/sales, are still much higher than at the market trough in 2016, and the risk of an earnings recession is, in our view, greater now. We also continue to recommend a value approach to equity investing, with an additional tilt towards GARP on the back of lower bond yields.

Chart 1. Liquidity much worse than at 2016 equity market trough

Macro strategy: Deteriorating macro outlook
After US markets posted the worst December since 1931, global equity markets reached our initial target of a 15-20% drawdown from the peak. As such, the equity market is much more attractive than it was in 2018. At the same time though, the macro environment has deteriorated, which increases the risk of an earnings recession. Various leading growth indicators are more negative than we previously assumed, central bank liquidity trends are pointing downwards and wage costs are continuing to rise. We note, on the positive side, that the Federal Reserve appears to be signalling a pause for rate hikes and that trade talks between the US and China seem to be progressing. However, we still believe that the increasing likelihood of an earnings recession favours sticking to a defensive stance towards risky assets. Our view on the equity market rebound in early 2019 is that it is likely a bull trap.

Chart 2. Higher risk of earnings recession than 2016

Equities: Entering the downgrade cycle
Security analysts around the world appear to be scrambling to adjust to a new reality of slowing global growth, while cost pressures from late-cyclical wages accelerate. Forward-looking P/E multiples have retraced to levels that in a historical context could be deemed reasonable, but the problem, we argue, is that the markets have discounted a profit growth slowdown, but not an earnings recession – and our indicators suggest this is becoming more likely. Style-wise, we remain stubbornly in the value camp, given the extreme valuation differential between the expensive and the cheap ends of the market. We advise complementing this bias with underperforming quality and GARP characteristics, given the pull-back in bond yields.

Equity strategy: Timing is everything – risk adjust
Today, we introduce a tool that could prove to help us in timing the market. As described earlier, major indices lost close to 20% from peak to trough. The factors behind the sluggish markets have been numerous, but in short, we explain it by overly high expectations that were challenged by deteriorating fundamentals. The core fundamental in any asset price is valuation. When valuation is extreme, be it high or low, an unexpected event is more likely to move the price. At the end of the day, the aim of marginal investors is to buy any asset cheap and sell it dear. Incorporating market risk into the equation helps. For most of 2018, our risk-adjusted valuation signalled utterly poor risk/reward. Currently this gauge is more neutral. Should it drop below 2016 levels, it could be an important stepping stone for a broad re-allocation into equities.

Nordea View Jan 2019.pdf

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