11 June 2013

Macro Strategy Update

US Equities Are Poised For New Highs

Despite the worrisome headlines in the media, we expect new highs in the US market. Fundamental data continues to show that recession risk in the US remains low and at the same time, growth is not strong enough to warrant a reduction in the Federal Reserves' quantitative easing program. The rally in equities, especially in the US, remains intact. Furthermore, there are reasons to expect a deflationary boomlet which will push markets higher.

Global markets have been wobbly since mid-May. Volatility has risen across all asset classes, including bonds. Even traditionally safe haven markets like US Treasuries and German bunds also lost value. Needless to say, commodities and emerging market assets suffered even more. It was the US dollar and the Japanese yen which provided a safe habour. Treasury inflation protection securities fell.

Figure 1: Performance of various asset classes in May

Based on the recent market action, one can reasonably conclude that:

1) The sell-off in markets is not due to a macro shock since Treasuries too were sold off. Typically when macro risk rises, investors rush for the safest and most liquid securities, which is usually the Treasury market. One such risk could be the resumption of the European crisis, which would lead investors to sell peripheral European bonds, and buy US and German government securities. The fact that Treasuries sold off while the euro did not fall much against both the US dollar and the yen suggest to us that investors are not worried about a macro shock to the global economy.

2) The lack of economic growth is not a worry, since Treasuries and income assets were sold off. Normally, when the economy is at risk of sliding into a recession, government bonds will rise. At the same time, income oriented securities like corporate bonds and REITs outperform equities on the basis that their income streams cushion any fall in capital values. In May, we saw US bonds and REITs underperforming the S&P500. We also saw defensive sectors like consumer staples and utilities underperform cyclical sectors like discretionary and financials. With such market action, investors seem to be signaling that they are not worried about a recession.

Figure 2: US sector performance in May

3) The prospect of rising interest rates is beginning to be discounted by the market. While yields on US bonds rose on fears that QE may end sooner than expected, we find that government bonds across major economies also rose in tandem with the US. Even in countries that practice fiscal discipline, like Germany and Singapore, borrowing costs climbed persistently in May. Hence it is not just the end of QE at play but perhaps demand for capital is also beginning to rise. After all, as rates have been so low for quite some time, a slight increase in demand for capital will cause borrowing costs to rise. Investors could well be anticipating higher demand for capital, due to an economic recovery in the future.

4) Emerging market assets continue to underperform, despite offering better “value”. In May, it was another month of underperformance by emerging market equities relative to developed markets. Since the beginning of the year, emerging market equities have offered better value, compared to developed market equities. Yet, the performance of emerging market equities struggled as earnings disappointed. A likely explanation is that emerging economies, after a decade of strong growth, is transiting to a slower growth phase while at the same time having to cope with higher costs in terms of rising wages and rents resulting from higher property prices. Profit margins and stock prices will be under pressure. We could see a prolonged period of underperformance by emerging markets, not unlike in the 1990s.

Image courtesy of Stockcharts.com

Figure 3: Emerging markets underperforming developed markets.

5) Commodities and resource currencies continue to struggle. The CRB Index continued its downtrend in May while the Australian and Canadian dollar fell against the US dollar. The structural change occurring in emerging economies and the slower growth in China is likely to dampen demand for commodities. Lower economic growth and falling demand for commodities is a strong headwind for resource countries and their currencies. The weak trend in commodity currencies also confirms the idea that the days of emerging market outperformance is over.

6) Investors gravitated to currencies where the equity market is outperforming. The US dollar has been stronger than most have expected, especially after QE3. Yet we find the US dollar holding up against the G7 currencies, and strengthening against emerging currencies. Incidentally, the US equity market is one of the top performing markets in the world, an indication that global fund flow is migrating to America. Global capital is flowing to the US as opportunities for higher returns rises.

7) Treasury inflation-protected securities are falling. TIPS, as they are usually referred to, fell as investors expect lower inflation in the future. The pessimist may point to a lack of demand as the cause for dis-inflation but there are good reasons why inflation in the US is not going to be high in the future. Energy prices are not expected to increase much, thanks to higher domestic oil production from shale oil. The still high unemployment rate means it will take a while before wages start to rise significantly. Hence, it is likely that inflation will not be a problem for the US in the near future.

Tying all the observations together, it is reasonable to conclude that developed markets, led by the US, are likely to continue their outperformance. This seems contrary to conventional wisdom. After all, the developed world is still reliant on unorthodox monetary policies. Yet, there may be a good chance that the US may experience a deflationary boomlet, a period of economic growth with falling inflation.

Manufacturing, which has been declining in the US, can still make a comeback in the USA as energy costs falls and American workers become more competitive. Oil production in the US has been rising (Figure 4), thanks to shale oil discovery and improved fracking technology. As a result, energy prices have not grown in line with an improving economy. Even OPEC is beginning to worry about the impact of US shale oil. Coupled with the general rise in wages in the emerging world, it makes sense for US companies to "in-source" manufacturing. If this trend develops (and it tends to be more long term in nature), it can give the US economy a tailwind in the future.

Figure 4: US Oil Production

This is probably why the US is leading equity markets around the world (excluding Japan). Even the recent correction does not change the nature of the bull market. We still see sectors most sensitive to the economy outperforming. Consumer discretionary and financials maintain their superior performance against the market while defensive sectors lag. Within the fixed income space, we see CCC-rated bonds outperforming BB-rated bonds. These are all signs that the risk of a slowdown or recession in the US is falling, and with the domestic sectors (consumer discretionary and financials) leading the market, it points to strength in the domestic US economy, confirming the idea that the US economy and its stock market offer superior opportunities for investors.


Despite the recent correction in equity markets and the increase in volatility, we remain positive on equities, especially with developed markets like the US leading the way. However the recent correction in equity markets may not be over and we need to be careful in looking for the entry point.

Portfolio Positions

Our core United G Strategic Fund has increased their allocations to US equities and we have recently also executed the switch into Japanese equities and global REITs (ref our last investment update) resulting in an overall overweight position in risk assets.

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