If any more evidence were needed of the precarious nature of current market confidence, it was found in the extraordinary trading pattern of Caterpillar1 stock on April 24, the day it announced first quarter results. The numbers themselves were robust, beating estimates. The company also raised 2018 profit forecasts by almost a quarter, as construction in North America and infrastructure projects in China continued to drive demand for their signature yellow machines. Shares rose steeply on the open, up 4.6%. Then analysts tuned in to the earnings call.

Partly, the sharp volte-face in the share price, which fell over 12% from its highs in a matter of hours as investors digested the implications, was a sign of the rarity of honest management communication in these generally platitudinous conference calls. CFO Brad Halverson said first-quarter adjusted profit per share “will be the high watermark for the year”. This seemingly innocuous statement had extraordinary ramifications. Some suggested that the violence of the market’s response was because Caterpillar has become such a bellwether of the global economy, driven as it is by demand from the two most important markets – the U.S. and China. It felt to us that the markets heard what they wanted to in Halverson’s words, namely negative tidings about the global economy, rather than a specific statement about CAT’s earnings.

We’ve spoken several times about the fragility of sentiment at the tail end of a bull market. Investors are currently desperate for direction, eagerly leaping upon anything that suggests a narrative that may play out over the coming months. CAT’s superb numbers were part of a noteworthy quarter for U.S. stocks, with tech and financials driving Q1 earnings growth of 21%, the highest in over nine years. And yet, investors are looking obsessively amid such positivity for signs of trouble to come. According to an analysis by BofAML, the markets rewarded the outperformers less than usual and punished the underperformers more.

Europe’s malady

Further confusion was heaped upon an already flummoxed market by statements coming from China and Europe. In what could well be another position-play in the opening skirmishes of a U.S./China trade war, the Chinese central bank announced that it was cutting reserve requirements for its banks after better-than-expected GDP growth, sending a clear message to the U.S. that it is preparing for more isolated times ahead.

A few days later, Mario Draghi made some cautious statements about the shape of the European economy. It’s becoming increasingly clear that, notwithstanding Emmanuel Macron’s efforts, structural reforms on the Continent are being implemented more slowly than we would have expected. This lack of progress has meant that European markets have relied on currency weakness to drive performance – witness the near-perfect negative correlation between the euro and the major European indices. Draghi’s dovishness was obviously intended both to signal to the markets that accommodative central bank policies would continue and to drive down the currency in recognition of the fact that it is only euro weakness that can stand in the way of further pain for European equities.

Five of the six key European indicators tracked by the team at BofAML are falling (figure 1 and table 1). Only once in history – 2006, when stocks were bailed out by the commodity super cycle – have markets not entered a slowdown following such signaling.

Figure 1. European Composite Macro Indicator

Source: BofAML.

Table 1. Summary of Europe’s macro signals

Inputs of EU Composite Macro Indicator

Indicator Direction
OECD EU Leading Indicator  Falling
German IFO Indicator  Falling
12-mth change in Pan-EU Bond Yield  Falling
Producer Price Inflation  Falling
Pan-European Cons. GDP Forecasts  Rising
Global Sell-Side EPS Revision Ratio  Falling

Source: BofAML.

Fixing on the widespread uncertainty that has seized hold of the markets, BCA Research set out some potential scenarios for the U.S. economy and stocks over the next two years. The base case presupposes moderate slowdown but still above-trend growth going into next year, predicated on the continued impact of U.S. fiscal stimulus, ‘animal spirits’ in the corporate sector and only moderate pressure from wage growth.

The optimistic case is based upon a more significant impact of tax cuts, with consumers spending the majority of the tax windfall and corporations embarking on significant capex-led expansion. In the pessimistic scenario, we enter a full bear market, with investors capitulating in the face of a lower-than-expected fiscal multiplier effect and the ramping up of U.S. protectionism. What seems clear to us is the extent to which the markets are relying on the U.S. tax stimulus to potentially drive performance, much as in 2006/2007, commodities came to the rescue of a stalling bull market.

Table 2. Three scenarios for US fiscal stimulus
Base case 2018 2019
EPS (Q4) 143.2 155.2
EPS growth (%) 15.0 8.4
Forward P/E 17.0 16.5
Index 2823 2971
% change 6.6 5.2
Dividend yield 2.0 2.0
Total return (%) 8.6 7.2
Optimistic case 2018 2019
EPS (Q4) 149.6 169.3
Forward P/E 17.4 16.5
Index 3021 3240
% change 14.1 7.25
Dividend yield 2.0 2.0
Total return (%) 16.1 9.3
Pessimistic case 2018 2019
EPS (Q4) 136.2 123.4
Forward P/E 15.0 13.0
Index 2247 1765
% change -15.1 -21.5
Dividend yield 2.0 2.0
Total return (%) -13.1 -19.5

Source: BCA Research 2018.

As we’ve said many times, we believe that it’s a matter of when not if as far as the coming recession goes. Saying this, while we’re not as optimistic as the most panglossian of BCA’s scenarios, we do believe that the global economy, driven by continued U.S. outperformance, may well surprise on the upside in the near-to-medium term. We believe that stimulus effects could prolong the bull market through the coming months, with inflation steadily rising. While this could obviously have negative ramifications for fixed income assets, we believe that equities – at least in those markets that provide supportive conditions – could outperform other asset classes going forward, although tail risk has markedly increased and volatility could remain higher than in the recent past.

More than the sum of the parts

At Man GLG, we combine a largely bottom-up investment approach with a deep engagement with the macro picture. Because of the range of asset classes in which we invest, our weekly cross-asset meetings of Portfolio Managers provide an extensive and multi-faceted portrait of the markets and their underlying economies. It’s often thought that macro investors, obsessively scrutinizing leading indicators, are best-suited to call major moves in the markets, while bottom-up investors only perceive these things in retrospect.

We recognize that an economy is merely the sum of its component parts and believe that the best way of trying to take measure of its health is by speaking to those at the front line – the management teams of companies who receive a daily picture of the condition of their end markets. This is why we insist upon regular visits to see firms in operation, why we demand in-depth and in-person discussions with management teams. With all the talk of AI taking over the financial markets, we continue to invest in this very human part of the investment process – site visits and management meetings. The furore surrounding Caterpillar’s conference call merely confirms to us the need to have a broad and deep pool of skills on the investment floor, better to try and sift between genuinely meaningful news and mere noise.

1. The following commentary is intended as an illustrative market view only. Nothing in this article should be interpreted as an endorsement or disapproval of any issuer presented or omitted from this commentary. Past performance is not indicative of future results.

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