Positive inertia still prevailed in November, but conditions for Santa Claus rally might be less certain

Darius Svidleras
Investment Portfolio Manager
 

• November was eventless month, with global equities moving higher without major catalysts;
• FED repurchase operations and corporate buybacks were among additional factors supporting equity prices higher during the autumn;
• Any less than stellar outcomes in relation to trade deal and Brexit might lead to volatility reemerging in December;

November turned out to be relatively dull month for financial markets. Overall, no significant events or major announcements took place throughout the month, and therefore, prices of global equities were still influenced by positive catalysts triggered in October. Specifically these catalysts included - intention to sign preliminary trade deal between USA and China; potential resolution of worst Brexit scenarios; additional monetary stimuli from FED and ECB; corporate results above analyst expectations and no major further deterioration in global macro¹.

But as impact of aforementioned factors was to large extent already played out during previous month, it should come as no surprise that price fluctuations during November were rather limited, changes in majority of trading sessions were miniscule, and in no single day index of global equities was able to move by more than 1%.

Global equities performance (02.10-29.11)

Source: Bloomberg

However, in our view, there might actually be more yet another more subtle reason why equity markets were doing particularly well in last two months. This reason is related to US central bank creating more liquidity inside financial system by engaging into repurchase operations. In simplified terms, it means that each night FED stands ready to repurchase treasuries that are being held by central bank counterparties, which predominantly include large US banks and financial institutions. Banks through this mechanism receive extra funds, which can be used elsewhere for their needs, including making investments into other financial assets. As of the last day of November, overnight funding provided through such repurchase operations constituted $88.45 billion, which is close to record high value. In addition, these operations helped to increase FED balance sheet by around $300 billion during autumn, with impact similar to what was previously achieved by process of quantitative easing. Speaking of which, by the way, it should be noted that ECB in November also has restarted bond purchases in the amount of EUR 20 billion each month.

Value of overnight repurchase agreements (USD'bln)

Source: Bloomberg​

FED balance sheet vs S&P-500

Source: Refinitiv

Creation of extra liquidity is positive for financial assets in the short term, but should be taken with some “grain of salt” in the longer term. Last time when FED was engaged in large scale repurchase operations was in 2008, right in the midst of the financial crisis, when commercial banks needed it the most, and even at that time overnight funding did not exceed $20 billion. But this September overnight repurchase operations started immediately with $53 billion and stayed at around $60-65 billion since then. Maybe there is nothing to worry about - banks are just using another route of cheap financing being made available to them through FED, or maybe, given that global recession risk has never been as high since 2008, as it is now in 2019, banks are being forced to take this extra liquidity to cover lack of available funds somewhere else in their operations.  This question cannot be answered right now, but let us just say that some risks exist.

In addition, it is worth mentioning another major force of buyers constantly operating in the market. This force is public entities themselves, buying their own shares from the market at record high amounts. In recent years more and more corporations are choosing to distribute their excess cash not through paying out additional dividends to shareholders directly, but by buying back their own shares from the stock exchange. In theory, such purchases, holding other things constant, create additional demand and lead to higher share prices. According to Ned Davis Research, if there would be no such buybacks since 2011, S&P-500 would be at least 19% lower right now. In 2018 such purchases constituted roughly $800 billion, or around 4% of total market value, and in 2019 it is expected that level of buybacks would be about the same. In fact, some research shows that corporations were almost singlehandedly responsible for US stock purchases since 2009, households, pension funds, insurance companies and other financial institutions were actually net sellers of stocks during this period.  

Buybacks and dividends of S&P-500 companies

Source: S&P Global

For now buybacks is not a problem, but actually one of the factors, magnifying positive equity returns in recent years despite some risk and threats. The problem might happen if economic slowdown would turn into recession and corporate earnings would significantly decrease. It would lead to lower equity prices as future prospects of companies would be revised down. But what is worse, most likely share repurchases would be one of the first things that corporate managements would be canceling to save funds. This would lead to much lower demand compared to what markets are used to in recent years. Therefore, just as buybacks were leading to higher returns on the market way up, their absence may lead to more severe decline on the market way down. 

But let us return to more relevant discussion, of what might impact financial assets in December.  Most important factor yet again would be trade talks between USA and China. We mentioned that both countries made progress in middle of October planning to sign initial deal. Since then we received almost no details of how this deal would look like and what would be some of the potential agreement terms. But just as in early and mid-2019 there were multiple announcements from Trump administration that trade deal is almost finalized and there are only few issues still remaining. We also remember well that after such announcements no deal in fact was happening, and Trump in the end was just announcing more tariffs on Chinese goods.

So would it be different this time? Equity markets are pricing in that such probability is highly likely and compromise will be made. We believe that risks of deal not happening should not be ignored. But the answer most likely would be known already by December 15^th, when tariffs on $160 billion of Chinese goods are planned to come into power. Chinese already hinted several times, that they expect USA to remove planned tariffs in order for deal to happen, and some sources even indicate that USA has to cancel not just planned, but also existing tariffs for China to sign the deal. Meanwhile, messages from Trump indicate that if Chinese will not sign the agreement, he will increase tariffs even more and that he is in no rush to sign the deal as soon as possible.

Another potentially important issue will be related to Brexit, with general election happening on 12^th December. It is expected that election results would allow UK parliament to accept proposed Brexit terms, and finalize exit process on softer conditions compared to what was feared before. But if some negative surprises would reappear after the vote, Brexit might once again become a destabilization factor for the market.

Finally, looking from the valuation point of view, the picture is currently mixed. Although the valuation has gone up fairly significantly during the last couple of months, the global equity market overall is still quite reasonably valued. At the 16.1 forward P/E, ACWI still provides 6.2% earnings yield, which compared to bond is very attractive level. The US, however, starts to get into historically expensive territory with a 18.3 P/E. Though due to extremely low  bond yields, this still provides a healthy risk premium over bonds.

The bigger problem however, is that much of the rise in forward P/Es came not from price increase, but from decline in expected earnings. And still even now analysts expect a 9.8% earnings growth in the US next year, down from 10.9% two months ago. To achieve such high growth in earnings, the global economic growth need to rebound significantly. If that does not happen, equities may become fairly expensive and be repriced.

GDP growth vs performance of global equities

Source: Bloomberg​