12 Sep 2012

Macro Strategy Update

Still Positive For Now

This is the third consecutive month that equities are up, ending speculation that it is a short covering rally and thus drawing more investors into the market. Fund managers, responsible for US$640bn, are increasingly more positive that the world economy will get stronger in the coming twelve months, according to the BofA/Merrill Lynch survey1. While we continue to be positive on taking on risks, the odds that this is a new bull market are low. In our view, investors should be mindful of the risks to growth even as they participate in the rally.

First off, we are still positive on assets sensitive to growth and expect the rally off the June lows to continue in the short term. Signals from various markets are indicating falling risk aversion. Cyclical equities continue to outperform while defensive stocks underperformed over the last 30 days (Figure 1). Equity investors are clearly in favour of growth assets as discretionary and financial stocks take charge. The fact that utilities are sold off is indicative of the change in investors' sentiment towards growth.

Figure 1: Sector Performance since 10 August 2012 (% Change)

The commodity sector is also confirming a return to the growth trade. Industrial metals made meaningful gains while energy prices remain steady after a previous surge (Figure 2). Commodities like copper and aluminium surged after China announced an 800 billion yuan investment in infrastructure2. While it takes time for such an investment to flow into GDP numbers, the fear of a hard landing in China should recede, which is a positive signal for global growth.

Image courtesy of Stockcharts.com

Figure 2: Industrial prices gaining strength while energy prices held steady

Signals from the fixed income markets also justify our positive stance on risk assets. TED spreads continue to make meaningful improvement in August while the preference for riskier bonds over Treasuries remains intact (Figure 3).

Image courtesy of Stockcharts.com

Figure 3: High yield and emerging market bonds outperforming Treasuries

We also see a resumption of the carry trade in currency markets. Funding currencies like the US dollar and the Japanese yen continue to fall relative to higher yielding ones like the Canadian dollar (Figure 4).

Image courtesy of Stockcharts.com

Figure 4: Carry trade is on in currency markets

European financials maintained their outperformance against the market last month (Figure 5). The Draghi put is having the desired effect with Spanish 2-yr bond yields falling from 5.28% to 2.89%. The commitment to buy unlimited bonds to gain control of short term interest rates is working to stabilise the European financial system. We also suspect that markets are discounting a favourable ruling from the German constitutional courts on the ESM (European Stability Mechanism), but it is likely that they will highlight the need for a referendum on further measures to integrate Europe.

Image courtesy of Stockcharts.com

Figure 5: Relative performance of European financials

So while we are positive on growth markets and the rising tide of bullishness, we remain realistic as to how long this rally can go on. For starters, many equity markets outside the US are still trending down on a long term basis. Emerging market equities, a region cited for their strong fundamentals without the debt excesses of the West, are technically weak with the index posting lower highs (Figure 6). The saving grace is that the lows are higher each time.

Image courtesy of Stockcharts.com

Figure 6: Emerging markets still trapped in a downtrend

A former market darling in currencies, the Australian dollar, is also suffering technically (Figure 7). While it may be held hostage to lower growth in China, continued underperformance in the Australian dollar may indicate rising risk aversion.

Image courtesy of Stockcharts.com

Figure 7: AUD is poor shape

It is also of concern that industrial stocks are not outperforming (Figure 8). This does not speak well for global manufacturing, which suggests weakness is to be expected going forward. It is thus not surprising that CEOs of large industrial corporations are cautious regarding their earnings outlook3. Certainly the recession in much of Europe and the slowdown in China are having a material impact on the major economies.

Image courtesy of Stockcharts.com

Figure 8: Industrial stocks continuing its underperformance

Finally, despite bond investors buying yield, it is clear that within the high yield space, caution is still being exercised. Bond investors have not shown a clear preference for riskier CCC-rated bonds in the whole of 2012 despite a rising high yield bond market (Figure 9). This could signal a weaker economy in the future, hence the preference for stronger, healthier companies.

Figure 9: Investors have been buying safer high yield bonds

Conclusion

The short term outlook is positive, as indicated by how various markets are responding. Investors are increasingly getting bullish and are buying risk as global policy easing is expected given the pervasive weak economic data. Still, we are not looking from rose tinted lenses and continue to see potential long term weakness. Enjoy the rally for now.

Portfolio Positions

Still no change for now. We are watching the markets closely and will seek your approval to take profit from some of our risk positions when we feel the market has reached certain price points.



References
1. Fund managers turn upbeat on economy: Merrill Lynch survey. 15 August 2012. cnbc.com
2. China's Roads-to-Subways Construction Spurs Stocks Rally. 7 September 2012. Bloomberg News
3. US companies gloomy about earnings growth. 10 September 2012. FT.com

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