Yield Curve Inversion with Equities Near All-Time Highs

Apr 07, 2019 | Dann Cushing


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After a few days of acclimatizing to the partial US yield curve inversion, equity markets...

...resumed their steady ascent. The S&P and TSX rose for seven days straight, gaining 3% and 2% respectively. 

 

With the S&P only 1% away from the 2018 all-time highs, it seems logical that corporate guidance during the upcoming earnings season will be very important. Yet on further reflection, perhaps not: the environment for risk assets has materially improved since summer 2018, with the US-China trade dispute on a clear track for resolution and with the Fed completing its rate-increase cycle far earlier than expected. From a macro perspective, the only lingering question is whether the negative feedback loop of falling business confidence impacting GDP growth (or more specifically, Capex spending) has been halted – and clearly markets are expressing a strong opinion on this. If you are a Bayesian thinker, you have had to adjust your prior quite meaningfully of late.

 

With that backdrop, it is not unreasonable to expect that management teams may actually get a free pass on Q2 guidance. The logic would loosely be that it is too early to expect companies to have seen a turn in their business levels (true), and that 2019 growth was always expected to be a second-half event anyway. That notwithstanding, three sector themes do seem quite apparent:

  • Industrials – capex spending has been ground-zero for the Q4/Q1 economic deceleration. With uncertainty remaining high throughout the quarter, Q1 numbers risk being materially below expectations. This seems particularly true for the auto & auto parts sector, where management guidance hasn’t changed but high frequency industry data shows sharply lower sales (research note attached). Broad weakness in the sector may create a tactical buying opportunity in the equity of companies like Allison Transmission (your idea) or Brembo (mid-cap, brakes). 
  • Consumer Discretionary – the US employment report on Friday showed that the labour market continues to be historically strong.  At the same time, consumer spending tends to tightly track with lower inflation (chart below), so with inflation expectations continuing to fall, the set-up for US-focused Consumer Discretionary equities (ex. Home Depot) appears quite positive.