12 Sep 2013

Macro Strategy Update

The Risks Are Manageable

In today’s environment, it is easy to see the risks investors face. The uncertainty in the Syrian situation continues to pressure oil prices, monetary policy could change at the coming Fed meeting, and emerging markets continue to remain vulnerable to global fund flows. Yet when we look at these risks objectively, we conclude that investors are likely to be rewarded by staying invested. Recent market action suggests growth and risk taking remains the dominant force, lowering the need to take defensive measures despite a lackluster performance over the past month. The odds are high that markets can overcome such risk.

Equity markets have gone nowhere since our last strategy report. If the correction in stocks is indeed over, then it had been rather mild, retracing only 4.2% from the last high to the most recent trough. If this is the case, then the fact that this had occurred despite uncertainties from a Syrian conflict to Fed tapering says a lot about the resilience of the market.

As we write, the events in Syria continue to evolve, the latest being the offer by Syria to give up its chemical weapons to international supervision. The case for a military strike led by the US grows weaker even as Congressional support looks weak. Correspondingly, oil prices have stopped climbing for now. Investors should watch the performance of oil prices relative to energy stocks for signs of any oil price shock (Figure 1). Any sustained and sharp spike is likely to indicate that rising energy prices are based on non-economic factors, just like in 2008 where financial speculation in commodities continued despite slowing global economic growth, resulting in a financial shock to the global economy.

Image courtesy of Stockcharts.com

Figure 1: Oil prices relative to energy shares

Fed tapering is another source of concern for investors. Rates have risen, in anticipation of the Fed cutting down on bond purchases. The concern is that if rates are too high, economic growth may suffer. However, we are not there yet. For now, rates are not high enough to snuff out business activity, at least that is what the market is telling us. We continue to see outperformance by cyclical and financial stocks, while consumer discretionary and auto stocks continue to lead the market. Furthermore, we are getting a similar confirmation from bond markets in that the spreads between the highest and lowest risk junk bonds continue to fall. These suggest that economic growth is likely to continue for at least the next six months despite the 10-year Treasury yield rising to 2.99% (Figure 2).

Image courtesy of Stockcharts.com

Figure 2: 10-yr Tresury yields

As for Fed policy, given how rates have moved over the past four months, the odds are high that the Fed will adjust its bond buying program next week, while at the same time reinforce its commitment to maintain the zero-interest rate policy, subject to how the economy plays out. The most recent jobs report is a good reminder that although the US economy is growing, the quality of growth is still not as robust as one would expect in a normal recovery. As the chart below shows (Figure 3), the economic recovery since the middle of 2009 has been weak when we use jobs creation as a gauge, compared to the average past recoveries in the US economy. As long as the Fed continues to adopt employment as a guide, zero interest rate policy looks likely to stay for some time.

Figure 3: Labour market recoveries

Fears of a hard landing in China were also eased given a slew of economic reports that suggest growth is stabilising. Exports grew more than expected and higher than the previous month, industrial production accelerated and surprised the consensus, while retail sales inched up further. All these came while the Chinese leadership implemented targeted stimulus measures to support small and medium size companies, to prevent the world’s second largest economy from slipping off their targeted 7.5% GDP growth rate. The Chinese stock market seems to agree, with the Shanghai market tracing out a double bottom in early July and is now up 15% (Figure 4).

Image courtesy of Stockcharts.com

Figure 4: Bottoming process in Shanghai stock market

Positive surprises from China have led to emerging markets having a short term reprieve. Currencies have recovered somewhat, while bond prices have stabilised. A slowdown in the rise of US rates can give the appearance of stability in financial markets as investors begin to nibble on perceived value in emerging markets. We remain cautious as fund flows remain negative for emerging markets, according to fund tracker EPFR1. Furthermore, it takes more than a couple of months to resolve economic imbalances, especially for countries like India and Indonesia. We would rather wait for emerging market bonds to improve, especially on a relative basis, before turning positive on emerging markets.

Image courtesy of Stockcharts.com

Figure 5: Emerging market bonds still underperforming

Meanwhile the European story continues to build momentum. Purchasing managers in Europe are more positive about business prospects, sending the composite PMI index to a two-year high. Concerns about the German elections, due 22 September, have faded as the campaign remains lackluster amidst voter apathy. It is not surprising, considering that the German unemployment rate, currently at 6.8%, has been and continues to trend down (Figure 6). Angela Merkel is likely to win the election and lead a coalition to form the next government. Responses to the next crisis in the eurozone is not expected to change. So for now, the economic recovery is giving the eurozone a reprieve from its structural problems. This is seen by how European financial stocks continue to outperform the market (Figure 7).

Figure 6: German unemployment rate trends down

Image courtesy of Stockcharts.com

Figure 7: European financials outperforming the market

Finally, over in Japan, economic growth for the second quarter was upgraded from 2.6% to 3.8%. Strong corporate investment was seen as a driver of growth. This has boosted confidence and it is likely that the sales tax increase will be implemented. A stronger economy makes it easier to enact reforms, and the continued territorial disputes with China is likely to be an impetus to push on with reforms. Despite being one of the fastest growing developed economies and the best performing stock market globally, valuations in Japanese equities have contracted despite a doubling of earnings growth. This contrasts with the multiple expansion seen in US and European equities where earnings growth are nowhere as strong. One could either see this as a trap, where earnings is not sustainable, or an opportunity where stocks still have plenty of room to catch up with earnings growth. With the yen still 20% cheaper than a year ago, we are inclined to believe in the latter.


If we do get better clarity from the Fed next week, chances are global equity markets will resume its rally. Europe and Nasdaq have overcome the recent correction and are at new 52-week highs. Other major indices like the S&P500 will probably follow suit. After considering the potential downside risk, our conclusion remains unchanged from last month. Investors should continue to stay invested in equity markets.

Portfolio Positions

No changes for now since our last rebalancing.

1. Investors pull out $6 billion from emerging market funds. 10 September 2013. The Economic Times.

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