9 Oct 2012

Macro Strategy Update

Less Bad Is Good For Equities

October is the month of stock market crashes - think 1929, 1987, 1997 and more recently 2008. Yet this is the month where the worst six months of the year ends, and this is another reason for under-invested fund managers to raise equity levels. Still, the economic backdrop remains woeful although we are beginning to see green shoots. The odds that the news flow will turn less bad are rising, a precursor of better times ahead.

The final quarter of the year is when professional money managers chase performance. Career risk matters when one's fund is lagging the market. It is better to stick with the consensus than be contrarian and wrong. With momentum rising in equities and risk assets in general, this is the last quarter for investors to generate returns to match the market. On a year-to-date basis, the S&P 500 is up 16%. Money managers, especially hedge funds who charge an exorbitant amount of fees, are only up 4-6%1. The temptation to abandon one's bearish view and join the market is strong.

The latest BoA/ML fund manager survey2 reveals more optimism on the global economy. Pessimism on Europe is fading as investors are raising exposure to European equities. Still, survey participants revealed that the US fiscal cliff remains a key concern, but apparently not enough to douse the rising positive sentiment on the global economy. Since the survey was unlikely to have fully captured the Fed's unlimited bond purchase program (the survey was closed on September 13, the same day as the Fed announcement), it is likely that fund managers are even more bullish now. This is likely to sustain the rally off the June lows.

From a contrarian point of view, when the consensus is bullish, one should always grill the prevailing view. Fortunately, we continue to see signs of improvement from various asset classes, signaling a "risk-on" mode. Also, there is news that the global economic slowdown is losing momentum - another harbinger that things are getting better.

The performance in equity markets suggests investors are buying into economic sensitive stocks. Financials, consumer discretionary and technology stocks are outperforming defensive sectors like consumer staples and utilities (Figure 1). Since the summer rally started, the cyclical sector is up 15%, compared to the defensive sector's 11% return.

Figure 1: Cyclical sectors outperforming defensive sectors since June

It is also worth noting that the consumer discretionary sector is making an all-time high (Figure 2). Develeraging, the new normal and the death of the US consumer may have been key tenets of investing in recent years, but the fact that consumer stocks are breaking records is a sign that businesses catering to the consumer is facing healthy demand, debunking the myth that consumption is on the decline. This actually bodes well for the world largest economy, which is largely consumption based.

Image courtesy of Stockcharts.com

Figure 2: Consumer discretionary sector making a record high

In the bond space, although the economic slowdown has caused default rates in high yields to rise marginally from 3.3% to 3.5%, it is still well below the historical average of 4.8%3. Importantly, we see fixed income managers remaining neutral on the riskiest of the junk bonds. The differential between BB-rated and CCC-rated bonds has not changed much since 2012 (Figure 3) and appears to be falling, signaling a willingness by investors to buy the riskiest bonds. Again this shows an improvement in credit conditions and better economic times ahead.

Figure 3: CCC-rated bonds not underperforming BB-rated bonds

The global economic slowdown is also showing signs of receding. While it is still early days, strength in the US offers hope that the days of positive surprises will be returning. PMI surveys in the US on both the manufacturing and services sector came in better than expected and indicated a return to expansion (Figure 4). Importantly, new orders surged, raising the odds that the expansion is sustainable.

Figure 4: US PMI survey

The survey also reveals an intention to raise employment, especially in the manufacturing sector. This is confirmed by the latest report on US employment, which may be fodder for political debate. While the media argues over the supposedly strong improvement in the labour market, a month before the presidential elections, investors would be wise to note the upward revisions to prior data4. For July, the non-farm payrolls data was revised upwards by 28%. Similarly, the August reading was revised upwards by 48%. While the data may be old, they are more accurate, which suggests that the economy is healthier than it was initially made out to be. Now that hours worked and earnings are rising, it is likely that the pace of hiring is set to continue. Economically, things are not as bad as they seem to be a couple of months ago.

Over in Europe where the economic pain is most acute, the less bad syndrome is being detected. Apart from France and Spain that are still reeling from a recession, sending their composite PMIs to a 42- and 4-month low respectively, German's September manufacturing PMI is at 47.4, a six-month high, up from 44.7 in August. It is a similar case for Italy, at 45.7 from 43.6 in August. Yes, they are still contracting but it is less bad. Meanwhile, bailout recipient Ireland is enjoying a resurgence in economic activity, with the composite PMI at 53.0, a 17-month high. While it may be early, the odds that Europe is able to stop the economic hemorrhaging is rising. Markets are also signaling this with European financials base building (Figure 5).

Image courtesy of Stockcharts.com

Figure 5: European financials base building since late 2011.


The last time we had a less bad syndrome which was a conducive environment for equities was in 2009. After reeling from a major financial crisis and a sharp contraction in the global economy, equities began to rally despite business activity still in contraction mode, albeit at a slower pace as the months progress. Coincidentally, the IMF was downgrading global growth prospects back then, as they are doing today5. It is likely that we are in a similar situation where better bad news drive markets higher. Stay positive and invested.

Portfolio Positions

No change to our current portfolio positions for the time being. As mentioned in our last investment update, we are looking to take profits from some of our equity funds when certain price points are reached. This will then give us some ammunition to buy back equities when markets eventually correct.

1. Sourced from HFRX Indices.
2. BofA Merrill Lynch Fund Manager Survey Finds Comeback in Sentiment Towards Europe. 18 September 2012 BoA/ML
3. U.S. Default Rate Rises to 3.5% as Junk Bond Yield Falls to 6.57%. Barrons.com 10 September 2012
4. Employment situation summary. 5 October 2012 BLS.com
5. IMF Sees Heightened Risks Sapping Slower Global Recovery. 9 October 2012 IMF

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