Stockwatch: Is it premature to sell equities?

Is New Year optimism for the global economy and equities, now undermined by reality? What profit plunges materialise, still tend to be company specific, like Dixons Carphone  (DC.)and Johnson Matthey (JMAT)  – than imply a macro downturn.

Shares in Deutsche Bank AG (DBK) are also down after the Federal Reserve deemed its US business in “troubled condition”, but this is a chronic restructuring/turnaround situation not an economic litmus test like banks can be.

As yet, the UK economy bumps along despite worries over Brexit. It will take more time for companies to reflect any shift in global prospects, although there are definite signs that things are not turning out as well as expected.

Mixed US situation, and a question over China

US momentum remains a pillar for the global economy, with firms reporting overall strong Q1 numbers and consumer confidence rising in May. Lower corporate taxes and a tighter labour market also affirm a sense the US will enjoy about 3% economic growth this year.

Manifesting against this, the Federal Reserve has gently raised interest rates six times since 2015, helping to squeeze the dollar higher thus potentially hurt exports. In that context, trade tensions with China and Europe – especially their tit-for-tat responses – don’t come at a great time. Yet it’s hardly rational to get bearish on the US economy which could rebound in H2 as tax cuts conflate with wage growth and profits’ momentum.

Trying to interpret such conflicts, the US stockmarket has turned down from linear growth to a volatile-sideways trend this year, back to mid-December levels when the corporate tax cuts were announced. Time will tell whether this is early-stage, cyclical downturn before genuine profit warnings appear, or just an overdue wiping away excess froth.

Meanwhile, China’s humongous debts are once again attracting attention. The latest OECD world economic outlook notes a rapid increase in China’s private debt especially to property developers as real estate prices soar. It expects China’s growth to ease in 2019 with exports and investment, but singles out property/debt as high-risk to financial stability.

Obviously, we’ve heard this kind of warning many times before, and short sellers were forced to retreat and lick wounds. The flaw in the China bear case has so far been that financial risks are contained by the Communist administration’s steely control of banks and the economy, and growth rates still impressive by Western standards.

While the mandarins appear to be taking their eyes off the ball as regards the property sector, it has presented a variable risk for many years – so again, only time will tell.

Euro area affected by QE’s waning

While less vital globally, the chief surprise is Europe also because continental equity funds tend to get promoted to UK private investors as a means to diversify. Media attention has focused on our economy showing just 1.2% growth over the 12 months to end-March 2018 (in the ongoing squabble over Brexit) but the euro area is weakening now the boost from the European Central Bank’s (ECB) 2015-17 Quantitative Easing (QE) programme is fading; hence structural worries have re-emerged, such as trade imbalances with Germany and unemployment in Spain/Italy.

Q1 growth has halved to just 0.4% from Q4 2017, although factors such as cold weather, industrial strikes and flu may have been exceptional factors. With year-on-year growth supposedly 2.5%, it’s premature to assert a genuine fall, except that promoters of continental equity funds probably got over-enthused by the ECB’s stimulus boosting market returns. Some extent of reversion-to-mean was inevitably due.

Italian voters’ potentially turning eurosceptic at the next poll therefore re-kindles an existential crisis for the eurozone that has smouldered on since debt issues in H2 2011 and Greece saw various rebellions.

Financial markets are sensitive also because professional investors are a pure form of the globalist liberal elite – George Soros being a titular example – who despise surging nationalism versus the EU. Threats to its capability are thus liable to jolt sentiment to “risk-off” as some investors perceive the threat as more serious than it may truly be.

The EU’s budget commissioner has fuelled popular outrage, saying and re-tweeting: “The markets will teach Italy to vote for the right thing”, quite the same as Soros now implores the British to come to our senses or suffer economically, as he co-funds a campaign for a second EU referendum.

Yet the experience of June 2016 appeared to show “project fear” instilling enough revulsion helping tip the vote to Leave; thus it adds to a sense of uncertainty.

Marginal growth downgrades for Europe

As yet they are small: typically from about 2.4% to 2.1% GDP growth for 2018 and 2.0% to 1.8% for 2019, though may encourage the European Central Bank to defer raising interest rates from March 2019 (as expected) to September 2019, and be more explicit in its forward guidance.

The hope is, rates won’t rise until well past the expiry of QE, the ECB is currently expected to enact over this October to December. All such could still change if Italy’s trend to financial instability spreads to other European economies, though the situation may overall be less risky than H2 2011 when stocks plunged.

European growth is currently stronger and its banks in sounder health with greater liquidity, whereas seven years ago the big fear during the sovereign debt crisis was contagion.

‘Buy the dips’ remains affirmed

Inevitably, an element of portfolio de-risking has appeared in response, with. one investment bank strategist advocating safe-haven assets such as US Treasury bonds, the Japanese yen and gold: “Equity buyers are unlikely to return convincingly until Italy’s politics are better resolved”.

This could be anytime July to September according to when the next election is finalised. Yet the very next day stockmarkets recovered most of their falls, affirming “buy the dips” before a genuine sell-off had even materialised.

Admittedly, some of this rebound relates to energy stocks amid volatile oil prices; yet it implies genuine profit warnings are needed to kick the prop away from stocks, given their dividend yield appeal.

Thus, it looks premature to sell unless corporate updates worsen in a way that implies optimism for 2018 was top-cycle fantasy. Markets just recently hit an air pocket of surprise, but all-considered the risks are tolerable.

If Greece was any guide to the continental psyche, Italy will indeed “vote for the right thing”, re-aligning itself with the euro, given the financial penalties will be harsh for a country with debts 140% of GDP. There has been another sign of strain in the grand European project, if too soon to call its demise.

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