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The Pin That Pricks The Bubble?

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By Roman Chuyan, CFA

  • Our equity model’s outlook for the S&P 500 remains negative, we maintain defensive positioning.
  • I explain why we think that investors are underestimating the damaging effects of the epidemic. 
  • Corporate earnings continued to stall in Q4-2019.

Stocks rebounded strongly in February from their earlier pullback as concerns about the coronavirus epidemic gave way to renewed optimism. The S&P 500 index has gained 4.9% so far in February, as well as year-to-date. However, non-US equities continue to underperform, dragged down by emerging markets:

The coronavirus epidemic has been the driver behind recent market moves. There are now over 64,000 confirmed infections and almost 1400 deaths from the virus – five times more than I wrote about just two weeks ago. The epidemic originated in Wuhan, China, and remains centered there due to China’s harsh quarantine of the province and to travel restrictions imposed by other countries. Concerns that drove a brief market selloff in January disappeared quickly, and investor consensus now seems to be that the effect of the virus will be limited and temporary.

We think that investors are underestimating the damaging effects of the outbreak. This view is based on already-reported disruptions in supply chains and their potentially significant economic effects, all happening amidst a fragile macro backdrop (extreme valuation, slowing global growth, and high debt). Below are some of the reported effects and assessments.

1. Travel, entertainment, and tourism hit
Most major airlines around the world have canceled or significantly reduced their China flight service. In the US, United Airlines and American Airlines said this week that they would not resume normal service to mainland China until April 24, almost a month later than planned. Among the first tangible effects here in the US is a decline in the number of Chinese tourists – lucrative customers for travel, entertainment, and luxury retailers, with average spending of about $6,500 per person. The number of passengers flying between North America and China is 75% below last year’s level, according to financial data provider Quandl.

2. Supply chain disruptions
Foxconn, a major supplier to Apple, said that it will be the end of the month before even half of its facilities are operating. The auto industry has already been hit hard by the disruption, especially in Asia, but the effect is being felt globally. Nissan temporarily closed one of its factories in Japan after running short of components, after Hyundai in South Korea did the same. Fiat Chrysler warned that it might shutter one of its European plants. This disruption is happening as the US auto industry is already reeling from high costs and declining non-US sales, resulting in declining earnings and cash flow.

3. Fragile macro backdrop
These economic disruptions wouldn’t be nearly as troubling if they occurred during a period of economic strength, but global growth is already weakening. For example, China’s (official) GDP growth at 6% in Q4-2019 is the slowest since 1992, and the Euro Area’s 0.4% annualized is the slowest in seven years, since the European Financial Crisis (see chart on the next page). In one assessment, Capital Economics predicts that the epidemic might cause the global economy to contract this quarter.

The problem is not the brief downturn itself, but that we’re unprepared for it. Financial assets are priced for perfection, and leverage is extreme everywhere. Total US corporate debt is over $15.5 trillion, 74% of GDP. Earnings stalled last year (see Earnings Focus). Losing even a small amount of cash flow in industries that are already overextended might start a credit crunch. The disruption might be just the pin that pricks the bubble.

Fitch just cut the rating of Kraft Heinz from investment-grade to junk, BB+, citing the company’s high leverage. Around 40% of investment-grade debt is like that. Was Kraft Heinz the beginning of a crunch?

Non-US GDP Growth, 10 Years 

The US remains almost the only reasonably healthy large economy. But even here consumers are alone in supporting growth, while manufacturing stalls:

Earnings Focus

Earnings continue to stall in Q4-2019

Earnings reporting for the fourth quarter of 2019 is nearly complete, with 77% of companies reporting their results. Although the Price-to-Earnings Ratio is currently inactive in our model, quarterly earnings are closely watched by investors. In this section, we provide a regular overview of earnings trends during quarterly reporting seasons. 

Operating earnings for the fourth quarter grew by 0.9% year-over-year – a positive but low rate of growth. This is the fourth consecutive quarter of near-flat earnings, which previously happened in 2016 (see chart). Non-U.S. economic woes, rising labor and material costs, and a currency effect (the strong dollar) contributed to weaker profits in Q4, according to Factset.

The Industrials, Consumer Discretionary, and Materials sectors all exhibited declines in earnings of around 10% from the same quarter last year (see chart on previous page). The Energy sector lagged the most, with a whopping 43% decline in Q4 earnings. The typically defensive Utilities sector leads growth at 21.6% YoY EPS growth. The Telecom, Financials and Health Care sectors have also reported strong results, all growing their earnings at more than 8%. The Telecoms beat earlier analyst estimates by the widest margin, 7.5%, followed by Technology at 7.2%.

About Model Capital Management LLC

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