Nordea View: Classic Overconfidence

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Today, we launch our new cross-asset strategy product, Nordea View, where we outline why we believe volatility is here to stay, with a negative equity market bias. We include a rather intriguing chapter on the growing number of canaries that highlights additional risks. Our analysis also strengthens our previous conclusion that valuation will matter even more for stock-pickers ahead.

CLASSIC OVERCONFIDENCE ABOUT THE FUTURE

Since late January 2018, we have periodically seen the return of equity market volatility. This has happened despite a generally positive growth environment in which GDP forecasts for the major economies have been raised. For us the volatility has to do with stretched valuations, high margin expectations for 2019 in every corner of the developed world, and overweight equity positioning – all of which need a continuous flow of positive macro surprises to survive.

LEADING INDICATORS SHOULD CONTINUE SOUTH

Global stimulus effects are reversing. We see 3-6 months of a falling trend in global business surveys and a tendency for negative macro surprises. This should then be followed by a period of more balanced surprises, but we do not expect a return to the situation in 2016-17 with basically only positive surprises. Global liquidity is also a risk factor as central banks are starting to reverse their QE programs. We also believe that inflation risk is real in the US (see Inflation at an inflection point), which should push the US 10-year yield towards 3.5%, a level that we think would be problematic for US stocks given that our calculations imply just north of a 6% expected return.

Thus, we see continued volatile equity markets, with a negative tilt. What we will look for to change our defensive view are signs of stabilisation in leading indicators, lower margin expectations and reduced investor equity overweight. It will be hard to fulfil all of those conditions, and believe two out of three might do given our view of no recession in 2019. Currently, however, the score is zero out of three.

TOO MANY CANARIES TO IGNORE

There have been plenty of interesting events (canaries) in recent quarters, such as the popping of a cryptocurrency bubble, liquidity problems in Chinese conglomerates, US subprime auto defaults soaring, widening of the Libor-OIS spread, the blow-up of inverse volatility products (XIV), and bloodshed in select emerging market currencies. Instead of viewing these events as idiosyncratic, we argue they reflect something more worrisome: global growth is slowing and the cost of capital is on the rise.

EQUITY VALUATION AND MARGIN RISKS ARE MOUNTING

Profit-neutral valuation levels like EV/sales (Stoxx Global 1800, including all three regions) are also in uncharted territory for the median company, which leaves stocks unusually sensitive to rising interest rates, we argue. We also see a medium-term issue in that profit margins are already at all-time highs and are expected to improve further, with 2019 forecasts in particular looking vulnerable. With wage and input cost pressure mounting, coupled with a slowdown in growth, it suggests to us that these rather lofty forecasts are at risk.

EQUITY STYLE ANALYSIS POINTS TO VALUE

We are perplexed to see continued US value weakness; especially given that we have seen rising interest rates. In our view, rising interest rates should lead to smaller valuation differences and point to relative value strength. We maintain our belief that valuations will grow in importance in stock-picking and that investors should adopt an over-the cycle approach to valuation given the margin risks we foresee. In Europe we see some signs of a value comeback, utilising our own back-testing data, which also demonstrates that both value stocks and reasonably priced quality look ripe for a relative comeback.