1 September 2011

Macro Strategy Update

Caution is Advised

As markets continue to consolidate in the month of August after the sharp decline, investors are faced with the prospect of recession and policy missteps. While bullish investors have been touting cheap valuations, we continue to be guided by market signals which have yet to signal a return to bullish trends. We get mixed signals from the US but it is Europe that is troubling us, and therefore we continue to exercise caution.

Despite a very weak Philadelphia Fed survey data and plunging consumer confidence, the latest revision to US GDP gave us some comforting news. Yes, second quarter growth was revised downwards to 1.1% (from 1.3%) but corporate profits, cashflows and investment data continue to show growth.

Interestingly, corporations in the US continue to be profitable despite high energy prices and supply chain disruptions (mainly affecting the auto and tech industries). Non-financial profits continued its uptrend since the recession ended. Importantly, the domestic economy remains healthy enough for corporations to make decent profits. According to the Bureau of Economic Analysis, domestic profits of non-financial companies increased in the second quarter by $84.4 billion, compared to the first quarter of $19.7 billion.

Figure 1: After tax profits of non-financial businesses in the US

Businesses in the US continue to be flushed with liquidity as cashflows rise. Healthy corporations are a pre-requisite for increasing hiring and capital investment. That is why domestic private investment continues to rise in the second quarter. Unfortunately, as the housing market remains in the doldrums, much of the capital investment is flowing into non-residential fixed investments (equipment and software). Increasing productivity does not usually lead to additional jobs, which is why unemployment in the US continues to remain at around 9%.

Figure 2: Corporate Net Cash Flow

Figure 3: Gross Private Domestic Investment

Figure 4: Real non-residential investment: equipment and software

We now find ourselves in a rather perplexing situation. While surveys have shown that business and consumer confidence have suffered as a result of financial market upheavals, production and sales data paint a completely different picture. There is a difference between what businesses and consumers feel, and how they act. Perhaps this is transitory and with the passage of time, either confidence rebounds or production and sales data begin to fall. This is where market signals (which move in real time) will help us in our analysis.

Both trend and sector analyses tell us that we are currently operating in a bear market. Major market indices are below the 200-day moving averages, and the trend of higher highs and higher lows has been broken for many markets. Sector analysis says the same thing, with cyclicals, small caps underperforming the market while defensive sectors outperforming. Market signals tell us to expect tougher economic times ahead, and possibly a bear market.

Figure 5: S&P 500 large cap index

Figure 6: MSCI Emerging Markets Free Index

Figure 7: S&P 500 Consumer Discrestionary Index

Figure 8: S&P 500 Consumer Staples Index

The credit market is also signaling recessionary times. The riskiest part of the high yield market continues to underperform as investors reduce risk, preferring higher rated companies as economic uncertainty rises.

Figure 9: BA Merrill Lynch US High Yield CCC or Below Effective Yield

TED spreads, an indicator of risk aversion, have also been rising. This is also compounded by what is happening in Europe. We have already expressed our negative views on Europe previously and fear that markets are no longer ready to accept any more of the kicking the can down the road mentality currently adopted by European leaders. This is shown by how much European financials have underperformed the broader European equity markets.

Figure 10: Treasury-EuroDollar Index

Figure 11: Dow Jones Europe Financials


Although corporate profitability remains healthy, the signals we receive from markets are a cause for concern. The current trend is bearish until proven otherwise. We will need to see conclusive evidence that investors prefer cyclicals to defensives, risky to risk-free before changing our minds. Equities do rally in bear markets, especially when the news flow begins to turn positive in the short term. This gives investors an opportunity to reduce risk in portfolios. The consolidation we saw last week provides a good base for a short rally.

In light of the current market risks, our United G Strategic Fund has a reduced equity exposure of 35%, with the balance in bonds, cash and gold.

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