PORTFOLIO POINT: The economic signals are not pointing to a year-end rally. Growth is still slowing, and there are problems ahead in the US, Europe and China.
The August rally in cyclical equities is, rightly in my view, faltering. I do not expect 2012 to repeat the year-end rallies of 2010 or 2011. This is partly because I think the global growth slowdown is continuing, and partly because I see a possible triple policy disappointment: in the US, in Europe and in China. The downside risk for cyclical sectors is that earning downgrades spread beyond commodity-related sectors.
There seems two crowded trades in global equities: by geography, overweight the US; by sector, overweight defensives. Lopsided positioning means that equity investors are on high alert for signs that cyclical sectors outperform. Squint at Exhibit 1 and cyclicals did start to outperform through August. But that rally is now faltering. I do not expect it to re-start:
First, global macro remains weak and the risk is that there are further downgrades to global growth forecasts. While macro surprises have inflected – notably in the US (Exhibit 2) – it seems unlikely that last year’s pattern of year-end positive surprises (and fleeting upgrades to consensus GDP forecasts) will be repeated.
Several factors contributed to last year’s second-half growth improvement in the US: a fall in petrol prices from May to December 2011; restocking following Japan-related disruption to global supply chains; the draw-forward of investment spending to take advantage of a year-end reduction in investment incentives; and an unseasonably warm northern winter. This year, in contrast, there is no special Japan-type factor; petrol prices have been rising from early July; and concerns about fiscal policy are more likely to delay, rather than bring forward, investment spending.
Moreover, global growth indicators are significantly weaker than a year ago. Global sentiment is deteriorating, with the global purchasing managers’ index below 50. Global trade volumes are on the cusp of contracting, something not seen since 2009 (Exhibit 3).
Industrial commodity prices also signal no imminent growth recovery. Base metals are broadly flat, while iron ore prices are tumbling. The exception is oil, but arguably that is due to supply-side concerns. That makes for an awkward mix: slowing growth lowering industrial commodity prices, with supply-side issues causing growth-dampening energy (and food) price increases (Exhibit 4).
I won’t detail my views on the risks surrounding policy (see Cross-Asset Strategy: Sunset On Summertime Rally, 16 August). The short story is that our US team does not expect imminent Quantitative Easing in the US; there are several hurdles to executing major ECB action; and the Chinese policy response continues to lag expectations. (See Vincent Reinhart on the Jackson Hole meeting: The Message From The Mountains, 30 August.)
However, it may be that cyclical sectors have factored in a lot of bad news. I’m not sure. The downgrades to earning forecasts so far have been concentrated in resource sectors (materials – which includes mining – and energy). Forecast earnings for other cyclical sectors – technology, consumer discretionary, industrials – have held up well through this year.
Exhibit 5 shows consensus 2013 EPS forecasts by sector (MSCI All Country index) from the start of this year. Forecasts for technology and consumer discretionary have increased through this year; industrials have seen trivial downgrades. There have not been broad-based cyclical downgrades.
The concentration of sector-level downgrades matches a similar regional concentration: big downgrades have been concentrated in Europe and China (Exhibit 6).
The downside risk for cyclical sectors is that earning downgrades spread beyond Europe, China and China-driven global sectors. Our analyst Adam Parker, for example, continues to expect further substantial downgrades to 2013 consensus earning forecasts in the US. The global team remains cautious on equities overall. More to the point, it’s very unusual for cyclical sectors to outperform in a weak equity market.
Gerard Minack is head of global developed market strategy at Morgan Stanley.