E Markets: Windmills

Just then they came in sight of thirty or forty windmills that rise from that plain. And no sooner did Don Quixote see them that he said to his squire, "Fortune is guiding our affairs better than we ourselves could have wished. Do you see over yonder, friend Sancho, thirty or forty hulking giants? I intend to do battle with them and slay them. With their spoils we shall begin to be rich for this is a righteous war and the removal of so foul a brood from off the face of the earth is a service God will bless." Chapter VIII – Don Quixote 1605 by Miguel de Cervantes

We maybe tilting at windmills as the relentless rally up in risk in the last week for US equities begets ever more analysis as to why markets react to policy and economic data as bulls beat bears. The cause and effect of why shares are bid in the US and Europe, less so in Asia and emerging markets matters. Knowing what caused the rally matters more than the rally itself, as it will be the underpinnings for the next cycle of selling. The abnormality of the last week stands alone - Stocks up, Dollar up, Oil up, Bonds up, Emerging Markets down. The cracks are in the logical inconsistency of it all, bonds and stocks can’t rally together forever, nor can the USD rally with commodities. Emerging markets depend on growth and easy money and yet the weakness last week seems to suggest more a zero-sum game in play for value. The bulls will list out better 4Q earnings, less fears about US/China trade, less fears about China growth, less US political troubles – ie. no new government shutdown – and further easy money promises from numerous central bankers. Bears continue to point to the growth disappointments of Europe, the troubles in China and doubting of its data, ongoing political issues in Europe from Brexit to Spain to Italy and Germany, along with the usual geopolitical problems from Russia, to India/Pakistan to Mexico and Venezuela. The four stories that play out next week will matter significantly to how markets see the windmills of cause and effect – they might be giants or they may be more grist for the millstone. 

China bank lending exploded last month will it continue?

1)  China. Is this optimism that the US/China trade talks lead to a March 1 deal or if not an extension in the deadline? According to a Reuters report, China offered to boost its purchases of U.S. semiconductors in exchange for lower U.S. tariffs even as the talks seem inconclusive on intellectual property or state subsidies. The underlying status of talks will become more obvious with the Trump tweets on this next week along with the China auto sales and home price data. 

2)  Fed. Or is this hope that the FOMC is next going to ease – driving another risk parity rally - with the 1.2% drop in US December retail sales – worst drop since Sep 2009 – along with a higher weekly jobless claims shifting the Fed policy games on balance sheet reduction and rate normalization. The FOMC minutes will be critical in assessing the reaction function to the present data. 

3)  ECB. Similarly, is the EUR weakness due to German near recession and Italian confirmed recession or because the ECB is more likely to reverse from its QE end and talk for rate normalization? The numerous ECB speeches from Praet next week along with the ECB meeting account will be seen as critical in judging this point. 

4)  Brexit. Finally, we see the confusion of Brexit still bleeding over the UK economy and yet the GBP holding stable, perhaps because of the inevitability that without a deal yet acceptable both Europe and the UK will delay any divorce. 

There are many undercurrents to cause and effects in markets, as every cause produces more than one effect. We will found this out next week in the readings of the FOMC minutes as they compare to those of the ECB. Present policy expectations are like windmills – they might be giants blocking the next advance up in risk as not hiking isn’t the same as easing, nor is freezing the size of your balance sheet the same as continuing to expand it. What matters is what the US, Europe, PBOC, BOJ, and others do with their policy more than one action alone. 

Question for the Week AheadIs this more than a short-squeeze for stocks? There is a growing view among analysts that the present 8-week rally up in the S&P500 is more than just a short-squeeze from the 4Q correction. Some argue that the FOMC and other central banks are now going to continue the easy money liquidity, others claim that the efforts for China stimulus and the likely Trump/Xi deal on trade mean 2019 growth will beat present reduced expectations. The flip-flop of bearish to bullish price action in US shares from December 24thto the present has become legendary. The rise in shares despite weaker expectations for 1Q stands out for the S&P500.  

According to FactSet, the fourth quarter, companies are reporting earnings growth of 13.1% and revenue growth of 7.0%. For CY 2018, companies are reporting earnings growth of 20.1% and revenue growth of 8.9%. However, analysts expect a decline in earnings in Q1 2019 and low, single-digit growth in earnings in Q2 2019 and Q3 2019. 

  • For Q1 2019, analysts are projecting a decline in earnings (-2.2%) and revenue growth of 5.3%. 
  • For Q2 2019, analysts are projecting earnings growth of 1.0% and revenue growth of 4.7%. 
  • For Q3 2019, analysts are projecting earnings growth of 2.4% and revenue growth of 4.5%. 
  • For Q4 2019, analysts are projecting earnings growth of 9.1% and revenue growth of 5.0%. 
  • For CY 2019, analysts are projecting earnings growth of 4.8% and revenue growth of 4.9%.
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