Atis Krūmiņš
Head of Investment Management
 

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 15th, 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 12th 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​

1Please, see our November report for more detailed discussion on these factors
DISCLAIMER

Warnings

  • This Marketing Communication is not considered investment research and has not been prepared in accordance with standards applicable to independent investment research.
  • This Marketing Communication does not limit or prohibit the bank or any of its employees from dealing prior to its dissemination.

Origin of the Marketing Communication

This Marketing Communication originates from the Portfolio Management unit (hereinafter referred to as PMU) – a division of Luminor Bank AS (reg. No 11315936, with registered address at Liivalaia 45, 10145, Tallinn, Republic of Estonia, represented within the Republic of Latvia by Luminor Bank AS Latvian branch, reg. No 40203154352, address: Skanstes iela 12, LV-1013, Riga, hereinafter - Luminor). PMU is involved in the provision of discretionary portfolio management services to Luminor clients.

Supervisory authority

As a credit institution Luminor is subject to supervision by the Latvian Financial Supervisory Authority (Finanšu un kapitāla tirgus komisija). Additionally, Luminor is subject to supervision by the European Central Bank (ECB), which undertakes such supervision within the Single Supervisory Mechanism (SSM), which consists of the ECB and the national responsible authorities (Council Regulation (EU) No 1024/2013 - SSM Regulation). Unless set out herein explicitly otherwise, references to legal norms refer to norms enacted by the Republic of Latvia.

Content and source of the publication

This Marketing Communication has been prepared by PMU for information purposes. Luminor will not consider recipients of this Communication as its clients and accepts no liability for use by them of the contents, which may not be suitable for their personal use.

Opinions of PMU may deviate from recommendations or opinions presented by the Luminor Markets unit. The reason may typically be the result of differing investment horizons, using specific methodologies, taking into consideration personal circumstances, applying a specific risk assessment, portfolio considerations or other factors. Opinions, price targets and calculations are based on one or more methods of valuation, for instance cash flow analysis, use of multiples, behavioural technical analyses of underlying market movements in combination with considerations of the market situation, interest rate forecasts, currency forecasts and investment horizon.

Luminor uses public sources that it believes to be reliable. However, Luminor has not performed independent verification. Luminor makes no guarantee, representation or warranty as to their accuracy or completeness. All investments entail a risk and may result in both profits and losses.

This Marketing Communication constitutes neither a solicitation of an offer nor a prospectus in the sense of applicable laws. An investment decision in respect of a financial instrument, a financial product or an investment (all hereinafter “product”) must be made on the basis of an approved, published prospectus or the complete documentation for such a product in question, and not on the basis of this document. Neither this document nor any of its components shall form the basis for any kind of contract or commitment whatsoever. This document is not a substitute for the necessary advice on the purchase or sale of a financial instrument, a financial product.

No Advice

This Marketing Communication has been prepared by Luminor PMU as general information and shall not be construed as the sole basis for an investment decision. It is not intended as a personal recommendation of particular financial instruments or strategies. Luminor accepts no liability for the use of the Marketing Communication content by its recipients.

If this Marketing Communication contains recommendations, those recommendations shall not be considered as an objective or independent explanation of the matters discussed herein. This document does not constitute personal investment advice or take into account the individual financial circumstances or objectives of the persons who receive it. The securities or other financial instruments discussed herein may not be suitable for all investors. The investor bears all risk of loss in connection with an investment. Luminor recommends that investors independently evaluate each issuer, security or instrument discussed herein and consult any independent advisors if they believe it necessary.

The information contained in this document also does not constitute advice on the tax consequences of making any particular investment decision. The estimates of costs and charges related to specific investment products are not provided therein. Each investor shall make his/her own appraisal of the tax and other financial advantages and disadvantages of his/her investment.
 
Risk information

The risk of investing in certain financial instruments including those mentioned in this document, is generally high, as their market value is exposed to many different factors. The value of and income from any investment may fluctuate from day to day as a result of changes in relevant economic markets (including changes in market liquidity). The information herein is not intended to predict actual results, which may differ substantially from those reflected. Past performance is not necessarily indicative of future results. When investing in individual financial instruments the investor may lose all or part of their investments.

Important disclosures of risks regarding investment products and investment services are available here

Conflicts of interest

To avoid occurrence of potential conflicts of interest as well as to manage personal account dealing and / or insider trading, the employees of Luminor are subject to internal rules on sound ethical conduct, management of inside information, handling of unpublished research material and personal account dealing. The internal rules have been prepared in accordance with applicable legislation and relevant industry standards. Luminor’s Remuneration Policy establishes no link between revenues from capital markets activity and remuneration of individual employees.

The availability of this Marketing Communication is not associated with the amount of executed transactions or volume thereof.

This material has been prepared following the Luminor Conflict of Interest Policy, which may be viewed here
 
Distribution

This Marketing Communication may not be transmitted to, or distributed within, the United States of America or Canada or their respective territories or possessions, nor may it be distributed to any U.S. person or any person resident in Canada. The document may not be duplicated, reproduced and(or) distributed without Luminor’s prior written consent.