13 May 2013

Macro Strategy Update

Seasonality Effect Likely To Be Weak

Since our last report, US equity markets continued to rally, making new record highs. In contrast, the global economic landscape remains mixed, with Europe still in recession while the US continues to muddle along. This is a conundrum that investors face: how can stocks be at 52-week highs when economic conditions are not fantastic? It is compounded by the fact that we are entering the seasonally weak May-October period where equity returns tend to be weak. Should investors play it safe or continue to ride the rally?

Recent economic data a mixed picture

Starting with PMI numbers, countries with their manufacturing sector still expanding include the US and China. However, the pace of expansion has declined. The eurozone continues to be mired in recession, led by Germany where manufacturing PMI remains in negative territory. One bright spot is Japan, where the weaker yen is beginning to benefit exporters.

Germany's business ifo index is now into its second month of decline, with both expectations and current conditions falling (Figure 1). Eurozone consumer and industrial confidence declined, as did retail sales. Meanwhile the unemployment rate in the euro area continues to deteriorate, currently at 12.1%, the highest since the adoption of the euro currency.

Figure 1: Germany ifo index falling again

Across the Atlantic, the jobs picture in the US is prettier. After last month’s disappointing report that got markets worried, we now have confirmation that the US employment situation is doing alright. Besides adding 165,000 jobs in April, March and February numbers were revised upwards by 50,000 and 64,000 respectively. Leading indicators like temporary help services continue to rise, while the number of initial unemployment insurance claims is falling (Figure 2). These are signs that we are far from experiencing a recession in the US.

Figure 2: 4-week moving average of initial unemployment insurance claims

While economists debate on the odds of a recession, it is quite clear that the US economy is not in the pink of health. The economic recovery since 2009 has benefited businesses more than the average worker. The current economic cycle, when measured using industrial production, is in line with past economic expansions (Figure 3). However, the improvement in employment is the worst on record (Figure 4). This would probably explain why many are doubtful about this recovery.

Figure 3: Trend of past industrial production recoveries

Figure 4: Trend of employment market recoveries

The implication of such an uneven economic expansion is that there will be a disconnect between the stock market and the economy. Earnings ultimately drive stock prices, and with corporate profits at a record high relative to the economy (Figure 5), it should not be surprising that US equities are at record highs. Furthermore, with monetary policy in unchartered territory, valuation of risk assets is being pushed upwards. However, unless employment picks up substantially, there will be the question of sustainability of the recovery.

Figure 5: Trend of corporate profits to GDP

The disconnect between the economy and the market may be a stumbling block for investors. An alternative would be to consider how investors are allocating their monies in global financial markets. So far, the reading is rather promising. The risk of Europe imploding is likely to be on the decline for now, given that their financials are outperforming (Figure 6). Importantly, they have recently made a 52-week high as investors deem the shares of financials attractive. When financial stocks are doing well, the banking system is likely to be stable.

Image courtesy of Stockcharts.com

Figure 6: European financials finally starting to outperform.

We also see economic sensitive sectors like consumer discretionary, financials and housing making new highs and outperforming the market. Even in the fixed income space, investors continue to buy into riskier but higher yielding securities, thus implicitly accepting higher risk.

What we have witnessed over the past month is that the correction in global markets is likely to be over and a new uptrend is starting. Although it is occurring in the seasonally weak May-October period, investors should not be crippled by the past three years’ experience. The ‘Sell in May and Go Away’ adage works because there were actual catalysts to cause a market sell-off. Weaker earnings, recession risk, geopolitical risks or monetary tightening are some of these reasons. However, none of these are appearing on the horizon, at least that is not what the markets are signaling.


The market has so far taken the economic slowdown, Italian elections and Cyprus bailout in its stride. As we enter into the May-October period, we now face another reason to avoid equities, but judging from the positive signals we are getting from markets, and that once poorly performing markets are rising again, risk assets are likely to get a second wind this time round.

Portfolio Positions

If the trend keeps up, we are looking to realign our equity and bond holdings. We will be sending a recommendation shortly on our proposed positions.

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