Is Q4 bounce finished? Not if the inflation breakevens are moving higher; DAX has attractive risk-reward
* Equity markets appear to be rolling over again. True, most tactical indicators
are not signaling to buy anymore, but we believe that stocks will still end the
year higher than the current levels. Apart from seasonals, which are typically
positive in Q4, US CESI moved above zero last week, for the first time this
year. The backtest shows that when CESI goes from negative to positive
territory, stocks typically perform well over the next 1-6 months. In fact,
looking at the period since 2009, the hit ratio from this signal has been 100%.
* In addition, we stick with our September call that Chinese activity was likely
to stabilize, which is now seeing some confirmation. This is more visible on
the consumer side, with a pickup in retail and car sales, but also construction
starts are up significantly, and the latest M2 and PMIs have inflected higher.
* We don’t see the December Fed hike to be a significant problem for equity
markets. Historically, the first Fed hike has been a confirmation that the
recovery is sustainable, rather than the sign of a policy mistake. S&P500 has
tended to be higher six months post the first hike. Importantly, the Fed liftoff
might usher in a much-needed broadening in market participation. If stocks are
to perform, we believe a change in market leadership is warranted.
* The top chart on the right shows a big gap which has opened up between market
levels and Cyclical/Defensive sector performances. The market is trading
much higher than where Cyclical/Defensive relatives are. To be clear, a gap
also opened up in the later stages of the previous cycle; however, the current gap
is now markedly wider. Put another way, this divergence is probably a result of
the dramatic ZIRP/QE impact and is suggesting that it is getting maxed out.
* Apart from anticipated Fed action and rising two-year US yields, the turn in
inflation could be a catalyst for a broadening in leadership. Financials have
historically shown the greatest correlation with inflation breakevens, which
are bouncing at present. Growth style does well in a deflationary regime, but
Value performs better in reflation. Full sector analysis is in the report.
* Our current sector allocation is not OW Cyclicals, as we are unexcited by
Materials and Industrials, but we are positive on Tech and Consumer
Discretionary. In addition, we find Financials to be attractive. The key is
whether the sectors such as Staples and Pharma lose their appeal, and
surrender some of the significant past multiple expansion. If yields move up on
the back of a Fed move and the likely turn up in global CPI, then it would
be surprising in our view if the beneficiaries of ZIRP keep their leadership.
* Regionally, Germany stands out in the current setup: 1. If China is
stabilising, Germany should benefit, as it was one of the main victims of the
summer EM scare; 2. Resilient IFO argues against a big fall in German EPS;
3. ECB is likely to act further, which would constrain the euro, and Germany is
the key exporter; 4. DAX is heavily cyclical, benefitting from sector rotation.
Also, the subdued oil price helps DAX as it has no Energy weight; and 5.
Finally, DAX is trading at near 30-year PE lows vs the other markets, so not
priced for perfection. We note VW is only 1.7% of DAX weight now, and the
latest car trends in China argue against Chinese demand turning negative in ‘16.