The long awaited G-20 summit in Osaka came and went. For some of us who eagerly anticipated some credible headlines of actual earnings-accretive deals and news flow to justify these lofty valuations and over-hyped equity market, we were extremely disappointed. In layman terms (in fact, there is only a layman version as nothing else was said!), Trump and Xi Jinping met at the G-20 to agree to meet and continue talks further. Wow, now that is truly ground breaking and worthy of sell-side earnings revisions!
One could never have expected a better outcome with the S&P 500 up 1% and about to hit 3000. The fact that Trump had to make concessions is a sign of his weakness, not strength, as China has all the time in world till November 2020. Allowing Huawei to purchase high-tech equipment from US companies is not new; they were allowed to do so a month and half ago already. So much for "Huawei threatening our national security" when all the while it was yet another attempt to bully the Chinese.
Permitting Chinese visas and buying agricultural goods, weren't these already in place earlier this year? Few empty promises and positive headlines and some great photo shoots later, all have come back very pleased with themselves when nothing has actually been resolved. Sure, he was "kind" enough not to place 25% tariffs on the additional $300 billion worth of Chinese goods imported, but I would remind readers that tariffs of 25% for $200 billion worth of goods are still in place.
Now that the politicians have done their dutiful jobs by taking photo shoots in elegant suits skilfully pretending all is well and how much they admire their counterparts in the rest of the world, can we go back to fundamentals please?
On Sunday, when the world was still busy going through all the personal interviews, China's official manufacturing PMI was released -- printing at 49.4 for June, below expectations of an increase in May. This was confirmed by the Caixin Manufacturing PMI as well. The worrying fact was that most key sub-components slid to new lows -- namely, production lower at 0.4 to 51.3, new orders sub-index was 0.2 lower at 49.6, imports down to 46.8 from 47.1. Trade tensions have clearly dented business sentiment, new orders and business capex. This is still in place and will not change or improve till an actual deal is on the table -- and tariffs are lifted.
It is not only China that is hurting across the board. The rest of Asia seems to be in turmoil too, with Taiwan PMI dropping to 45.5 (lowest since 2011), South Korea lower at 47.5 vs 48.4, and even the Australia factory gauge is in contraction for the first time since 2016.
But the market can continue to rejoice in empty promises from Trump, I guess -- as we saw in December following his positive trade talk rhetoric after the Buenos Aires G-20 meeting, before he later changed course in May -- until we see real tangible economic growth or actual Fed cuts providing stimulus to the economy. The market will soon start to grow worrisome above 3000. If it stays there for too long, the rally will fizzle out. There tends to be a huge disconnect between reality and hope, but it can only go so far without real numbers to back that feeling.
The 7% rally in the S&P 500 since the low touched on June 3 has come from pure multiple expansion. According to Goldman, consensus has lowered their 2019 earnings per share (EPS) by $1 to $166 (just 2% year-over-year growth), but they were at +10% at start of 2019. Companies issuing negative earnings guidance has jumped to 87, the second highest on record, while one-month EPS revision has been most negative in Energy and Information Technology, according to Factset.
The next "real" catalyst for the market is second-quarter 2019 earnings reporting season kicking off from July 15 onward. Consensus EPS is expected to decline 1% year over year. Regardless of Trump "I like Xi, he is a good man" tweets, it is impossible to see companies talking as positively as Trump, because real profit margins peaked in Q1. The unemployment rate stands at a 50-year low (3.6%) and average hourly earnings have grown by more than 3% in each of the last eight months. Q2 will be expected to show the same profit margin decline, which should cap upwards earnings revisions.
Algos can chase the market higher on momentum and hopes, but without earnings moving higher along with it, there will come a time when bigger institutions and real money will start selling equities, as they will not be able to justify holding them at P/Es of 17x-18x. The last two months have seen dollar longs capitulate on the back of dovish Fed cuts, but with global growth falling and the Fed still battling on when to cut rates for the first time, the dollar will be bid going into July.
Equities, especially basic resource stocks have more than priced in any growth upside especially with base metals still trading weak on the back of physical excess supply and a lack of demand. This is not a time to go long China-focused cyclicals. It is a time to start shorting miners like Antofagasta (ANFGF) Kaz Minerals (KAZ.L), and the mining sector in general.
The divergence between Equities and Bonds or Commodities, like a rubber band, can extend for only so long till the tension snaps and reality bites.