Views From the Floor

In this week’s edition – Europe: A glass half empty?; A rising tide that sinks all boats; and crude talk.

Europe: A Glass Half Empty?

European Central Bank President Mario Draghi struck a somewhat optimistic tone on November 26, when, at a hearing in the European Parliament in Brussels, he said: “A gradual slowdown is normal as expansions mature and growth converges towards its long-run potential." While Draghi may be looking at the euro-area glass as being half full, we are at the opposite end of the spectrum given the recent economic data.

First, euro-area composite PMI fell to a 4-year low of 52.4 in November, with manufacturing the main area of weakness, but services also starting to see a slowdown. The PMI manufacturing index slipped to 51.5 in November and the gauge of services fell to 53.1, both the lowest in more than two years. In addition, the ZEW Indicator of Economic Sentiment for Germany rose to -24.1 in November. While this is an improvement from the -24.7 in October, it is still clearly in negative territory and remains well below the long-term average of 22.7. Germany accounts for about one-third of the euro-zone economy, so its performance has wider implications. Indeed, growth in the 19-nation currency bloc slowed to just 0.2% in the third quarter, the weakest in four years.

There are two views one can take about the data. First, is this just a mean reversion due to the financial conditions in Italy and the impact on European auto production from new regulations? Or is this something more sinister, such as a lack of traction from the Chinese stimulus? Either way, we believe that no good news will come from Europe in the next few months.

Figure 1. Euro-Area Composite PMI Falls to 4-Year Low…

Euro-Area Composite PMI Falls to 4-Year Low…

As of November 2018

Figure 2. …ZEW Remains in Negative Territory…

…ZEW Remains in Negative Territory…

As of November 2018

Figure 3. …Euro-Area GDP in Third Quarter at Weakest in Four Years

…Euro-Area GDP in Third Quarter at Weakest in Four Years

As of November 2018

A Rising Tide That Sinks All Boats

Rising yields are offering a credible alternative to equities.

First, 3-month US T-Bills currently yield 2.4%, more than the projected 1.9% dividend yield of the S&P 500 Index (Figure 4). This corrects one of the defining features of the bull market: investors now have an alternative to simply ploughing into high yield bonds and equities.

This paradigm shift has invited investors to reassess valuations in light of increases to the cost of funding and interest rate risk. As a consequence, the global equity de-rating continues (Figure 5). Indeed, the price-to-earnings multiple of the S&P 500 Index, based on the next 12 months of earnings, has fallen 17% in 2018, according to Bloomberg1 , the third-biggest drop in valuations since 1991.

Figure 4. S&P 500 Dividend Yield Versus 3-Month US T-Bill Yield

S&P 500 Dividend Yield Versus 3-Month US T-Bill Yield

As of 22 November 2018

Figure 5. 2018 Drop in PE Is Third-Largest Since 1990s

2018 Drop in PE Is Third-Largest Since 1990s

As of 20 November 2018. Note: P/E ratios based on expected earnings for the next four quarters.

Crude Talk

Following the washout in crude prices over the last two months, speculative positioning has shifted from the largest net long in history in Brent earlier this year, to the lowest net positioning in more than three years. As is usual with crude, some sort of overshoot to the downside has probably happened, and in the event of a year-end rally, crude could well participate.

However, when we think about the longer term, the supply side looks quite healthy, particularly onshore in the US. First, commercial hedging reached an all-time high of approximately 1.6 billion barrels earlier this year, meaning that producer cash flows were better insulated from crude price volatility than in previous oil price crashes. Second, the stock of drilled but uncompleted wells onshore in the US has also reached a record level -- at 8,545 for the week ended November 16, the highest since the EIA started compiling the data going back to December 2013. These wells are awaiting the final processes to begin producing oil, and can be thought of as an inventory.

So, it is reasonable to expect that the US onshore industry, whose balance sheet is in better condition than in previous cycles, will look to bring supply on quickly when prices rebound.

With contribution from: Pierre-Henri Flamand (Man GLG, CIO), Teun Draaisma (Man Solutions, Portfolio Manager), Henry Neville (Man Solutions, Analyst) and Ed Cole (Man GLG, Portfolio Manager).

1 https://www.bloomberg.com/opinion/articles/2018-11-21/stock-market-is-even-worse-than-you-think-it-is/