Sell in May and Pray?

Thu, May 5, 2016 - 10:07am

Asset volatilities tend to move in tandem and rarely deviate for prolonged periods. While commodity, equity and fixed income volatilities have subsided substantially since the mid-February mini riot point, foreign exchange volatility is moving in the opposite direction. This is disconcerting for global equity markets (see chart) given the decade-long close inverse correlation and represents another non-confirming indicator of the latest “risk-on” phase.

Tack on the ongoing global trade struggles and a durable market advance from current extended levels is a high-risk, low-reward proposition. China’s greenshoots are a welcome development, nevertheless, we remain skeptical that this reflationary period will prove more than transitory as it has taken a progressively larger injection of liquidity in order to move the needle. Worrisomely, the Fed acknowledged that even the US economy is showing signs of fatigue despite the still vibrant labor market. Ultimately, profit trends dictate equity returns, and the profit outlook remains murky.

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We are currently in another earnings recession outside of an economic recession and Q1 will likely mark the nadir. Global EPS are on track to recover near the zero line as the year draws to a close, assuming no energy price relapse. Nevertheless, it is premature to expect a durable reacceleration in profit growth. The previous three earnings recession episodes (outside of an economic recession) ended with a significant rebound in global industrial production (IP) growth. At the current juncture, global IP is drifting lower despite the recovery in global manufacturing PMIs, underscoring that global earnings will remain stuck in a rut.

Bottom Line: In order for global equity bourses to recover on a sustainable basis, profits will have to come to life. Until a clear catalyst emerges, such as a durable depreciation in the US dollar, the news will remain grim on the earnings front. Under such a backdrop, a capital preservation mindset is still warranted, and we continue to recommend a defensive over cyclical portfolio tilt.

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