Earnings season and Brexit, two formidable challenges for equities

Equity and commodity markets rallied at the end of last week, sterling surged by the largest amount since March and safe haven assets fell. Investors cheered a “phase one” trade agreement between China and the US as well as signs that the EU and the UK could agree to a Brexit deal ahead of this week’s EU leaders’ summit. 

The US yield curve gives investors reason to cheer 

The green light to buy risk assets did not just come from the political sphere, there was also good news from the Federal Reserve and the US yield curve. The Fed agreed to bolster its balance sheet and purchase $60bn of short-term US debt from this week into Q1 or even Q2 of next year. This is positive for a couple of reasons. Firstly, it could ease pressure in the US repo-market, which had seen banks unwilling to lend to each other at the end of the third quarter. The fact that the Fed is back buying debt could lower short term lending rates, thus making banks more willing to lend to each other for the medium term. Secondly, the downward pressure on short term lending rates has meant that the US yield curve has moved back into positive territory for the first time since June. The inverted yield curve (when short term yields are above long-term yields), spooked investors because it is a major recession risk. Now that it has moved back into positive territory, albeit with a big helping hand from the Federal Reserve, investors might choose to look through the spate of weak economic data from around the globe, and we may see stock markets continue to move higher. The caveat to this is that we believe that three big events could be a bigger driver for stock markets in the coming days and weeks: the detail of the US/ China trade agreement, Brexit and US corporate earnings for Q3. 

Will US corporate earnings disappoint, again? 

US earnings season for the third quarter kicks off this week. There is growing gloom about the health of corporate profits in the US, and FactSet is expecting a 4.1% decline in earnings-per-share for companies in the S&P 500, which if true, would be the third straight quarter of declines for US earnings, the longest streak since 2016. Energy, materials, tech and finance stocks are expected to see earnings fall, which are major growth-sensitive sectors. If these sectors disappoint on the earnings front in the coming days, then it is likely to call into question the health of the US economy as we move towards the end of the year. Big banks including Goldman Sachs and Morgan Stanley have seen their earnings estimates slashed in recent weeks, for example, GS’s earnings expectations have fallen by 15% in recent weeks on the back of some failed IPO’s and weak global M&A business.GS, along with other Wall Street banks, are set to release details of losses associated with their stakes in WeWork, the serviced-office company that had its IPO pulled last month. Some analysts have estimated that GS had a stake worth nearly $250mn, so any write-downs associated with WeWork could be huge. 

Why the Vix is the most important indicator for traders this week 

As always with earnings figures, the most important part is the forward-guidance. Recent interest rate cuts from the Federal Reserve is likely to hit interest income for banks, and since rates are not expected to move higher for a prolonged period, and because there is a lot of uncertainty around the global economic outlook, we are not expecting the banks that are reporting this week to sound particularly hopeful for the future. Thus, stocks could be in for a rough ride. While global stocks performed well last week, this week the key metric to watch is volatility. The Vix index should be every trader’s friend this week, if it spikes on the back of a weak set of earnings data from the US banks, then we could see global stock markets fall. The S&P 500 remains in striking distance of a move back towards 3,000, however any move back towards this level could trigger a wave of selling pressure next week, especially if poor bank earnings follows any set back in the fragile trade deal between the US and China. 

Why optimism in the pound could be limited 

Brexit is also a key risk event this week. The EU leaders’ summit on Thursday and Friday is meant to be the deadline when the UK and the EU agree a Brexit deal. The 450-point surge in the pound to its highest level since July at the end of last week, was spurred by the positive comments from the UK and Ireland that a deal could be agreed regarding the Northern Irish boarder. This is the first time that Dublin has sounded positive that a deal could be reached, and markets reacted with gusto. Since then both Boris Johnson and the EU negotiators have urged caution and reminded the markets that they have a long way to go. At the end of last week, there was some easing in the pound’s gains. GBP/USD fell back to $1.2650, after failing to break above $1.27.This is to be expected after such a large surge to the upside. However, the real test of the Brexit negotiation will come at the EU summit later this week. If traders have pre-empted a deal that does not materialise then we could see a very sharp, vicious reversal in pound longs. 

What next for sterling 

Interestingly, GBP/USD’s 1-month risk reversal moved into positive territory last week, for the first time in months. This happens when there are more buyers of GBP calls (buy options), than puts (sell options). This suggests that the market could be warming to the pound, since short term risk reversals have mostly been in negative territory since the EU referendum in 2016. However, it is still too early to suggest that the tide is turning for the pound, and there has not been a mass unwinding of GBP puts, suggesting that the FX market is still waiting for a firm Brexit deal before unleashing more love for the pound. 

While we could see the pound continue to react in a positive way to any news headlines that suggest a deal between the EU and the UK is possible before the end of this month, there are plenty of hurdles ahead for the pound. If a deal is agreed with EU leaders later this week, it would still need to be ratified by the British parliament before October 31st, which is not a given, even at this late stage. Thus, GBP/USD may not rise in a straight line from here. 

European data and the Dax 

Elsewhere, Chinese export data is worth watching at the start of this week. Another month of declines could hurt the Aussie and Asian stocks. Some juicy European economic data is also released this week, including French inflation, German business sentiment and Eurozone inflation data. The German ZEW index, released on Tuesday, could have a big impact on the Dax, which so far has not been impacted by weak German economic data. The Dax is a mere 100 points away from its highest level so far this year. The current path of least resistance for the Dax is higher, thus, it may take a very weak ZEW reading, along with deteriorating US/China trade negotiations to knock the Dax off course in the coming days.