Back in July, Barclays rankled the bears and delighted those hoping it wasn’t too late to ride the S&P to ever higher highs by making a market “melt-up” their base case for US equities.
The rationale was fairly simple. Donald Trump and Xi Jinping had just struck a new trade truce in Osaka and the Fed was still set to ease policy.
“The open-ended nature of the truce, coupled with the looming 2020 Presidential election, probably means that both parties have incentives to continue kicking the can down the road”, the bank’s Maneesh Deshpande wrote at the time, adopting a 3,000 target for the S&P.
About a month later, things got dicey after Trump, irritated with what he perceived to be an insufficiently dovish rate cut, reignited the trade war, pledging to slap more tariffs on China starting September 1.
China quickly let the yuan breach the psychologically-important 7-handle, leading to a harrowing selloff, which was itself followed by a dramatic bond rally that eventually “succeeded” in inverting the 2s10s, much to the chagrin of the White House.
Reflecting on that bout of turmoil in August, Barclays’ Deshpande called the selloff “relatively orderly”.
Through it all, SPX 3,000 still seemed like a reasonable target assuming the Fed kept easing (which they did) and Trump would eventually be compelled to soften his stance on the new tariffs (which he was).
Fast forward a few months and Deshpande is out with his year-ahead outlook for US stocks. Barclays official SPX target for 2020 is 3,300, the same as BofA’s and 100 points below Goldman’s year-end base case. Barclays bases that on CY2020 EPS of $166 and a P/E multiple of 19.9X.
“Our ‘mini-bubble melt-up scenario’ appears to be materializing [as] recent data indicates the global manufacturing slowdown is stabilizing, and although we are not completely out of the woods, we do not expect it to morph into a recession next year”, Deshpande says, adding that the bank is “cautiously optimistic for a détente in the US-China Trade War, and monetary policy also remains accommodative around the globe”.
That’s generally consistent with the narrative coming out of most banks. The consensus macro view is coalescing around the notion that the slowdown in global growth is largely behind us – that an inflection catalyzed by tariff rollbacks, diminished odds of a “crash-out” Brexit scenario and, crucially, the lagged effect of rate cuts and dovish forward guidance, will play out into year-end and through Q1.
Deshpande notes that the Fed’s belabored efforts to explain why T-bill purchases are “not QE” aside, “the resultant liquidity injection is likely to have had at least some positive effect on risky assets” and besides, “the number of Central Banks that are in easing mode is at a record high since the 2008 credit crises”.
One of the key bits in Barclays’ outlook revolves around what usually happens during “easy soft patches”, defined as instances where the Fed eases policy in response to a softening in the economy as opposed to an outright recession.
“During actual recessions, despite aggressive Fed easing, equities still sell off on average [but] when the Fed eases during soft patches, equity markets rally significantly over the next one year (20% on average)”, the bank says.
History shows that most of these gains are precipitated by multiple expansion. Specifically, Barclays finds that “on average, P/E multiples have expanded by nearly 4 turns over two years”.
We’ve talked at length here over the past week or two about the extent to which recent gains have been attributable almost entirely to multiple expansion, as earnings growth decelerates (or turns negative) across multiple locales, including the US.
Deshpande goes on to explain the multiple factors that lead him to conclude that this is, in fact, a “soft patch” and not the beginnings of an outright downturn, but he includes a series of caveats explaining why we’re “still not completely out of the woods”.
For Barclays, the story is always the same on this front – and it’s always spot-on. It all comes down to China’s willingness (and ability) to bolster growth with aggressive stimulus and credit provision.
“Although the global industrial slowdown has been attributed to the US-China Trade War, in our opinion self-imposed deleveraging by Chinese authorities was also an important contributor”, Deshpande writes, on the way to noting that “over the past decade, global industrial PMI’s have closely tracked the China credit cycle with an approximate nine-month lag”.
As most readers are acutely aware, China has been reluctant to countenance “kitchen-sink” style easing this time around for fear of inflating bubbles and/or conveying to the world that Beijing has abandoned the deleveraging push which is paramount to untangling the absurd web of cross-holdings at the heart of the country’s labyrinthine shadow banking complex.
Barclays notes that while China’s credit cycle has troughed, “the recovery has not been as sharp as the past two episodes, primarily because Chinese authorities have not done the same amount of fiscal stimulus via public fixed-asset investment as in previous credit troughs”.
That’s true, but it’s also important to point out that demand for credit in the real economy seems to be lacking, which helps to explain why last month’s credit creation data was so disappointing.
After around 30 pages, Barclays summarizes their three scenarios, with the base case calling for “moderate upside” predicated on the above-mentioned “easy soft patch scenario” combined with modest earnings growth.
As for the downside scenario, it’s as follows:
Downside Scenario: If the US-China Trade War continues to escalate and the U.S. industrial economy fails to rebound it the soft patch might turn soggier, resulting in no EPS growth. As the macro environment deteriorates we would expect our PE to fall to 16.0x, which is ~1x below our current fair value. This would result in a ~15% decline in the SPX, but we view this scenario as unlikely.
And here’s the bull case:
Upside Scenario: In contrast, if there are significant tariff rollbacks and the industrial portion of the U.S. economy rebounds more than what is currently being signaled by LEI then EPS growth could move above 5%. At the same time, we estimate that momentum in the trade war resolution could push SPX PE another turn above our base case to 21.25x, around ~3x higher than when rate cuts began in July 2019 and around the average for historical soft patch valuation expansion.