Cat call reverberates in market echo chamber
The response to CAT’s Q1 earnings call laid bare the fragility of sentiment. In the echo chamber of markets investors sometimes hear only what they want to. Active managers that engage with management may have an edge when it comes to separating the signal from the noise.
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.
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
Table 1. Summary of Europe’s macro signals
Inputs of EU Composite Macro Indicator
|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|
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
|EPS growth (%)||15.0||8.4|
|Total return (%)||8.6||7.2|
|Total return (%)||16.1||9.3|
|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.Download full article
Opinions expressed are those of the author and may not be shared by all personnel of Man Group plc (‘Man’). These opinions are subject to change without notice, are for information purposes only and do not constitute an offer or invitation to make an investment in any financial instrument or in any product to which the Company and/or its affiliates provides investment advisory or any other financial services. Any organisations, financial instrument or products described in this material are mentioned for reference purposes only which should not be considered a recommendation for their purchase or sale. Neither the Company nor the authors shall be liable to any person for any action taken on the basis of the information provided. Some statements contained in this material concerning goals, strategies, outlook or other non-historical matters may be forward-looking statements and are based on current indicators and expectations. These forward-looking statements speak only as of the date on which they are made, and the Company undertakes no obligation to update or revise any forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the statements. The Company and/or its affiliates may or may not have a position in any financial instrument mentioned and may or may not be actively trading in any such securities. This material is proprietary information of the Company and its affiliates and may not be reproduced or otherwise disseminated in whole or in part without prior written consent from the Company. The Company believes the content to be accurate. However accuracy is not warranted or guaranteed. The Company does not assume any liability in the case of incorrectly reported or incomplete information. Unless stated otherwise all information is provided by the Company. Past performance is not indicative of future results.