October was a mercurial month with global equities rising 2.7% in USD terms despite clear evidence that the global economy continues to slow down. In fact, the global leading indicators from OECD have been declining for 20 straight months. The US chemical industry shows weakness to persist into Q2 2020, South Korea export data shows little signs of rebound in Asia and in particularly China, US employment is slowing down, and earnings growth has gone negative in emerging markets and close to negative in developed markets. The disconnect between what we observe in macro data and equity markets has many explanations but one of them is that equity investors are only discounting a soft patch for the economy before returning to trend growth. This is key assumption so any broad-based weakness in the US services sector and employment in general should in theory in set in motion a repricing of global equities.
19% rally in global equities has been fueled entirely by expanding valuation
multiples which to some degree can be justified as global interest rates have
come down reflecting lower inflation and growth expectations. We observe a clear pattern of lower
inflation rate translating into higher valuation multiple. This reflects lower
hurdle rate for return on capital for companies but also substitution effects
from bonds into dividend paying stocks, something we have talked a great deal
about during October in our daily equity updates.
In our Q4
2019 Outlook: The Killer Dollar we also showed how the USD is a key driver
of equity returns globally. Our findings suggest in the last three major USD
cycles that stronger USD coincide with strong US equity returns compared to
developed equities ex US and emerging markets. The stronger USD theme is also
important to be watching as the USD is a constraint on financial conditions and
global growth. For the time being we
remain defensive on equities but will switch to overweight as soon as leading
indicators are turning higher again and the USD is weakening.
Given the trajectory of macro data, the
geopolitical uncertainty on the rise and a bumpy ride on the trade deal we
still have the view that volatility could pick up in November and December although
this seems like a contrarian view as equities are climbing higher. The VIX is back to levels around
July before the August volatility kicked in. In our view equity volatility is
fragile to news on the US-China trade deal and US jobs data out today.
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