Why The Market Can Repeat The 2019 Rally

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Includes: DDM, DIA, DOG, DXD, EEH, EEM, EPS, EQL, FEX, FWDD, GLD, HUSV, IEF, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPY, SRTY, SSO, SYE, TLT, TNA, TQQQ, TWN, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VOO, VTWO, WFINX
by: Alex Vasylenko
Summary

With the escalation of the U.S.-China trade tensions and the further global economic slowdown, the market can repeat the beginning of the 2019 rally.

The global economic, political and financial conditions create a background for central banks to actively participate in the financial markets of their countries.

Regardless of the explicit slowdown in earnings, the U.S. corporate sector is in a favorable position compared to other advanced countries.

At the end of 2018, the market was in a downward trend caused by China-U.S. trade tensions, explicit global macro deterioration and excessive tightening of monetary policy by the Fed. This set the table for the S&P 500 Index to close in negative territory as investors sold their equity positions at a fast pace.

(Source: Equity flows have lagged far behind the rally )

Based on the factors above, central banks started to provide support for the markets and economy by inserting additional liquidity to Capital Markets.

The chart shows explicit growth in the Global Money Supply while the S&P 500 Index declined. Central banks pumped almost $1tn in liquidity into global markets for stabilization.

(Source: Bloomberg )

The additional liquidity from central banks continued lifting the U.S and global corporate debt to the record highs.

(Source: Most pronounced Debt-Equity Swap of all time)

And enhancing the companies' shares buybacks which are reaching records in the U.S equity market, as the inflow from investors falls behind.

(Source: Booming Buybacks Aren’t Likely to Slow Down – The Wall Street Journal )

Amid the global central bank inflows, Fed monetary policy experienced a drastic change in regards to raising interest rates at the beginning of 2019. Thus, after the guidance of 2 interest rate hikes claimed at the end of 2018, the Fed changed its position to 0 hikes in 2019, with signs of possible monetary easing.

The drastic change in U.S monetary policy and improvements in the U.S.-China relations allowed market participants to start closing their short positions and begin purchasing the U.S and world equities, boosting the global indexes to the highs.

(Source: Equity Market Movements: U.S., UK, and Germany )

Earnings Season

Market expectations of negative EPS performance from U.S companies in 1Q19 did not match the actual results. Thus, 1Q19 earnings and sales growth were positive at +5.63% and +5.51%, respectively, compared to market expectations of -3.4% EPS fall and just +0.7% revenue growth.

(Source: 1Q 2019 Earnings Scorecard )

While 1Q19 EPS growth didn’t cross into negative territory, this event is expected to appear in 2Q19, as analysts have reduced their expectations to a -0.22% EPS fall, based on negative tariffs impact accompanied with a slow global economic growth. The EPS growth is expected to accelerate in 4Q19 and 1Q20.

(Source: How 2Q 2019 S&P 500 EPS growth expectations changed)

The U.S Economy

The underlying factors in the U.S Economy remain strong.

The unemployment level in the U.S is the lowest since 1969, providing support to the strong consumer sector which is the major contributor to the GDP (65-70%).

(Source: U.S unemployment )

And the real wage growth creates a strong bulk in the U.S economy to perform well.

(Source: Annual US wage growth vs. inflation)

While the other parts of the GDP remain volatile:

  • Capital investments are subject to fluctuations based on the explicit slowdown in corporate earnings.
  • Government investments are negatively influenced by the prolonged government shutdown.
  • Exports are suffering from the negative impact of retaliation from the countries which were affected by the U.S. import tariffs.

Thus, the 2Q U.S. GDP is now expected to be in the range of 1.8-2.2%, compared to 4.2% in 2Q 18.

This gives the U.S a leading position in the Advanced Economies' real GDP growth expectations list for 2019.

(Source: Real GDP Growth)

Global Economy

The situation in the global economy remains challenging.

In May, the Global Macro Index posted the second biggest disappointment in the last 5 years.

(Source: Citigroup Economic Surprise Index)

With the global trade growth at the lowest level since the Financial Crisis 2008-2009.

(Source: Global Trade Collapsing To Depression Levels)

The slowdown in global trade growth is contributing to the global PMI growth fall, which stands lower than the 2009 pre-crisis level.

(Source: Longest losing streak for global PMI)

Possible Scenarios

The U.S.

The possible excessively negative performance of U.S. equity indexes and a slowdown in economic indicators will lead Fed officials to pursue an easing policy with 1-2 possible interest rate cuts in 2019 in order to arrange a "soft landing" due to the rising probability of a recession in the U.S.

(Source: Recession probabilities are increasing)

As evidence, the market is reflecting only a 2.8% probability that rates will be unchanged at the 11 December 2019 meeting.

(Source: TargetRate Probabilities for 11 Dec 2019 Fed Meeting)

EU

The slowdown in global trade and enhancing of the protectionism movements will negatively impact the export-oriented EU economy, which has been in a downward economic trend since 2018 that is currently stimulating the ECB to introduce new assets to its QE program.

(Source: Eurozone Economic Indicators: Growth Expectations vs. PMI)

China

After a massive credit injection of $685 billion earlier this year in January and an additional $424 billion in March, China is likely to continue its monetary stimulus with the possibility of fiscal stimulation of its own economy, as they respond to the recent U.S. - China trade negotiations failure challenging the economy and causing massive equity outflows.

(Source: China's Premier Slams Central Bank For Gargantuan Credit Injection)

Conclusion

The current global economic, political and financial conditions create a background for Central Banks to actively participate in the financial markets of their countries. Additional monetary and fiscal stimulus will likely push the global debt market further towards negative real and nominal interest rate territory, adding benefits for the equity class as a provider of real and nominal positive returns.

(Source: Negative-Yielding Bonds Are Breaking Records)

This creates an opportunity to consider U.S stocks as a good buy for the long term, as even if the U.S. corporate sector experiences a slowdown in earnings and sales growth, the U.S. economy will still be in solid condition, this will likely contribute to a strong corporate performance compared to other advanced countries. The additional liquidity inflows will continue to lift the U.S companies' buybacks programs and the amount of global debt with negative yields, providing background for strong U.S equity performance.

Investment Implication.

- Purchase of long-term U.S government treasuries, based on Fed monetary easing expectations.

- An open long position in gold, based on the expected devaluation of the U.S currency as a result of the stimulus.

- An open long position in U.S equities index, based on additional liquidity inflows.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.