The uncanny ability of JPM’s head quant, Marko Kolanovic – the man Bloomberg recently called “Gandalf” due to his predictive success – to call key market inflection points has been extensively documented on these pages, most recently a month ago when we showed that just after he said the “rally drivers are gone with downside risk ahead”, the market proceed to swoon, two months after the same Kolanovic correctly predicted that the “technical buying begins.”
We bring up Kolanovic because earlier today he released a new note in which he together with JPM’s Global Equity Strategy team lays out both the longer-term, as well as the immediate risks facing the market.
First, we lay out JPM’s longer-term concerns for the S&P500, starting with the same one noted previously by everyone from Zero Hedge, to Goldman, to Credit Suisse to Citi: profit margins, and specifically their lack of future growth as a result of relentless dollar strength. Here are some of the main ones:
Negative earnings effect from energy is likely to fade away, but strong USD will continue to exert some drag causing further negative revisions to current 2016 earnings growth estimates of 8.5%. Equity multiple will be limited from re-rating higher, in our view. The market is of age, already trading at close to 18x (NTM) P/E and we expect higher volatility going forward.
The current year is likely looking to print flat earnings growth—negative revenue growth roughly offset by some margin expansion and significant share repurchases. While buyback activity should continue to synthetically boost earnings growth in this lackluster economic environment, margin expansion is near full exhaustion and in 2016 will possibly turn negative for the first time in this recovery. This suggests that we need at least some top-line growth in order to avoid a possible earnings recession next year. In that vein, one of the biggest risks equities face is a continuation in the strengthening of the US dollar and the Fed getting ahead of the curve (“policy error”). We estimate that a 5-6% change in the USD TWI corresponds to ~3% change in S&P 500 EPS.
Then there is the question of the what a rising rate environment will do to equity returns. Here, JPM tries to walk a fine line and spin a contraction in financial conditions as if not bullish for stocks than hardly bearish…
Historically, higher rates have meant lower but not necessarily negative equity returns. Correlations between rising short-term rates and S&P 500 performance imply a negative relationship, especially in a lower growth environment like today. During previous liftoffs equity markets have typically fared well, but the macro environment was also more supportive—GDP is less impressive now at +2.25% y/y vs. +3.4% y/y during previous episodes and the USD has increased +10% y/y on a trade-weighted basis vs. basically unchanged previously.
Which brings us to another topic covered extensively here previously: the possible inversion of the yield curve as the Fed hikes the short-end while the long-end prices in policy error, or a failure to stoke inflation. Indicatively, the 2s30s is now the flattest it has been since February.
More so, the slope of the yield curve is also a factor to consider, with the worst case for equities being a rising rate scenario with a flattening/inverting yield curve. We are not there yet, with 10s/2s spread having averaged near 140bps.
And then it gets interesting: Kolanovic’ first prediction – expect not only higher volatility but higher levels of tail risk.
Also, higher rates have typically resulted in higher market volatility. While it may be difficult to quantify, certain parts of the market could be highly levered to the prolonged zero interest rate policy (i.e., long/short, distressed funds) which may require risk to be re-priced.
In our 2015 Outlook published last year, we forecasted that the average VIX level would increase from the 2014 average level of 14 to 16 this year. The average VIX level ended up at 16.5, very close to our forecast. While historically periods of falling volatility lasted much longer than periods of rising volatility, we again forecast an increase in volatility for 2016. Our forecast is for the average VIX levels to rise from the current level of ~15 to an average of 16-18 next year. We also forecast higher levels of tail risk.