“NEW WORLD ORDER – SHOULD FUNDAMENTALS MATTER?”
WHERE TO FROM HERE?
The S&P500 index is up 15% year to date. Eurostoxx is up 12%. As we await the details of the much debated US tax reform bill, there is some debate as to how much is priced in by the market already. When one looks at the impressive performance of the S&P 500, it is important to understand where that growth comes from. Chart 1 shows the change in earnings from Q2 2009 through Q3 2017 has been ~ 70% earnings driven and about 30% multiple driven. So there has been a genuine earnings driven rally. During the Q3 2017 earnings seasons so far, more than 76% of companies have reported earnings ~ 4.7% above estimates and above the 5-year average (source Factset). There is a genuine recovery. Now comes the question on the tax bill. No doubt the measures mentioned by President Trump can boost US earnings but I fear the market has priced most of that upside in. One of the issues is whether the GOP can successfully eliminate state and local (S&L) tax deduction, as an example, to pay for the revenue loss? Not only do the Democratic states get impacted by this loss, many Republican states suffer as well. Perhaps on the day of announcement the market could rally few percent higher but on any sort of delay or disappointment in the actual bill, there seems to be more downside than upside here?
The one argument I keep hearing from committed bulls is the growth of passive funds and their relentless buying of market and index funds to gain exposure to this growth. Be that as it may, it is prudent to monetize on gains and sit it out when valuations do look rich and all the heavy lifting is done by only a handful of stocks (FAANG stocks). Correlation in markets is almost 1:1 as everything is moving together in the same direction. It may just be time to start looking at sector and stock specific earnings growth, as there is selective value underneath the surface more so than chasing just the broader indices.
Outside of flows and yield chasing funds one thing is for certain, the dollar should start to, and has been, grinding higher slowly over the last few weeks. Yellen has started talking more hawkishly about rates going forward, and for good reason. The US economic data justifies it especially as inflation is expected to pick up slowly. This past week, ECB’s Draghi maintained QE asset purchases for this year while reducing the monthly purchases to 30 billion Euro/month from 60 billion Euros/ month starting from January 2018, but said he could keep the QE open
ended and extend it beyond September if need be. This was a much more dovish tilt that caught the markets by surprise and caused the Euro to fall 1.5% on the day against the USD.
The next catalyst for the FX markets is the appointment of the next Fed chairperson. An announcement is due imminently and the odds favour Powell currently, who, if nominated would be expected to keep the gradual pace of tightening. If Taylor is nominated, this may be perceived as hawkish, given his bias of higher rates going forward.
The dollar has driven the performance of most asset classes this year given the implications of reflation and loose monetary accommodation. Sterling aside (given Brexit/EU talks), the dollar should continue to rally against the Euro and Emerging market currencies given the tighter monetary policy path going forward combined with better economic data. Bond yields have been picking up over the last few weeks and Equities are celebrating as it implies “reflation.” If the rate of change of Bond yields is too fast too soon, this could upset the Equity markets.
Chart 1: Source of Change in the S&P Index 2Q 2009- 3Q 2017
Source: WSJ-Daily Shot
32 | ADMISI - The Ghost In The Machine | November/December 2017
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