Equity markets are now oversold (particularly Europe and Emerging markets), meaning that a technical rebound should occur soon. The question is that of the duration of the rebound. Earning season will be crucial to determine whether equity markets bottom out or continue to slide. While we do not expect any earnings disappointment, negative earnings guidance due to US-China trade war is a distinct risk.

We however keep a positive view on equities. Equities still are the asset class to overweight in a slow burning bond bear market like the current one. The current equity market correction is similar to the February one, even though the resilience may be lower this time due to higher yields and slower activity. Solid earnings reports, US mid-term elections, a cooling down of Italian risk and a EU-UK withdrawal agreement are potential positive catalysts. Seasonality will also be favourable.

Equity markets have been vulnerable since the beginning of the year due to the reduction in the liquidity issued by central banks, more fragile global economic growth (as it is now largely US-driven), higher oil prices and mounting risks: trade war (making the earnings season uncertain), Italian budget, Brexit etc. On top of that, higher bond yields against a backdrop of fears of US overheating are weighting on equities’ valuation. We have entered the last phase of the cycle, which usually sees more volatility in risk assets.

However, given where equities valuations are at the moment, we think that most of these risks are exaggerated. Macro imbalances are rising but are not yet elevated enough to generate a recession. The latter is probably at least one or two years away. It will happen when financial conditions will tighten too much (a by-product of too high interest rates) and corporate margins will compress too much. For the time being, margins remain at a very decent level thanks to corporates’ pricing power and muted labour costs.

On the macro side, the latest activity data are encouraging, pointing to a stabilization in Europe (industrial production, French Banque de France’s surveys) and China (external trade) and to the continuation of a steady pace of growth in the US (small business leaders’ and households’ confidence). In the meantime, core inflation readings remain muted.

Strategically, we continue to focus on high conviction stocks, as they usually outperform during the late periods of the cycle and also during downturns. We also continue to overweight European and US stocks as long as we have no visibility on Italian and Brexit developments.

What about China?

The People’s Republic of China has three major objectives right now:

1) Hurt the USA,

2) Prop-up their currency, and

3) Obtain cash to stimulate their economy.

Therefore, given the fact that U.S. treasuries are getting clocked, but utilities are rallying, I am convinced the jump in interest rates is due to the Chinese selling vast amounts of their treasury holdings. By selling them they:

1) Push U.S. interest rates higher which, hurts the U.S. consumer and possibly President Trump’s approval rating right before an election,

2) They get billions of U.S. dollars, allowing them make open market purchases of the renminbi, which supports its value in international markets, and

3) With all those Renminbi they can now freely spend inside the country of China to stimulate their economy. With one transaction they accomplish three major objectives.

This is the only thing that makes sense. And if this analysis is correct, once that selling subsides we are in for one major rally in the U.S. financial markets.