Time to re-enter the US? No, upside is limited at this stage of cycle, but too early to position for recession
the most worrying one any more – partly as it appears to be a very crowded
fear these days. Our key concern is with the US. There are good reasons
why US equities are having a hard time performing this year. The list
below could almost double up as a “recession watch” set of indicators:
1) State of US profit margins is an important consideration. These are
elevated and are showing signs of rolling over. S&P500 EPS has not grown
for a number of quarters now. Wages need to pick up, but given how poor
the productivity is in this cycle, ULCs could go up even with little wage
pressure. Margins were typically a credible lead indicator of the cycle.
2) A chart we have been highlighting all year remains a problem: HY
spreads, ex Energy, have decoupled from equities. The health of the US
corporate balance sheets is not as good as the aggregate numbers show -
median ND/E ratio has been moving up. This is a concern as credit was a
lead indicator of the cycle. M&A volumes are elevated, but not as a share
of market cap. Buybacks as a share of EBIT are at past peaks.
3) The end of QE has clearly adversely impacted the equity upside, see
the bottom chart. However, we do not see the current policy backdrop as a
problem. One should typically not sell stocks around the first Fed hike.
Yield curve is still not inverted, and real rates are not flashing red, yet.
4) The US business cycle is maturing. Many cycle indicators are near or
above the past peaks. On the positive side, the strength of the recovery to
date was much more muted than normal, and contrasts with the dramatic
initial drop, which could act to prolong the current upcycle.
Putting the above together, some of the longer term cycle signals are
increasingly worrying, with rising risk that US equities start making
sustained losses next year. At best, the upside potential for the US remains
limited, in our view.
Having said that, we think that one should not join the risk-off trade in the
next 3-6 months. Global equities are oversold near term. We are about to
enter the typically constructive time of the year - Q4. We think the nearterm
macro momentum is in fact picking up in the DM, as seen in US CESI
close to breaking into positive territory, and Eurozone CESI clearly
above zero. Fed is nearing, and it could be a positive catalyst, irrespective
of the actual decision, a case of "travel and arrive". Keep buying the dips.
Of course, it will be very difficult for equities in Europe, or anywhere else
for that matter, to decouple from the US directionally, when the US starts its
downtrend. The history was clear on this. What is also clear though, is that
regional business, policy and credit cycles have diverged significantly
this time around. These considerations should offer at least relative support
to Eurozone and to Japan, when the US equities start their downtrend. The
best way to shield against a worsening US risk-reward is to remain UW the
US equities in the context of the global portfolio, even on the way down.