14 Oct 2013

Macro Strategy Update

Still Bullish Despite The Risk

Last month, our macro view was that the reward of staying in equity markets was well worth the risk. Today, investors are faced with a potential US government debt default, which is the Republicans’ weapon of choice in negotiation with the White House. When measured using outstanding debt, the US government is 23 times larger than Lehman Brothers, hence its impact if a default occurs, is unthinkable. While Lehman Brothers defaulted due to the inability to repay her obligations, the US government is bickering over whether it should pay her bills. Unfortunately, the political circus is drawing investors’ attention from the more pertinent issue: the global economy is finally growing together.

Recently released PMI reports indicate that the global economy is on the mend. This time, it is not just the US economy that is contributing to global growth. Today, we have the eurozone, China and Japan giving a boost to global growth. The manufacturing PMI surveys show the US, Japan and China expanding at an accelerated pace (Figure 1). Meanwhile, over in Europe, the UK, Germany, Italy and Spain continued the manufacturing recovery.

Figure 1: September 2013 manufacturing PMI survey

It has been a while since all major economies in the world were growing at the same time. For the last few years, as the eurozone was entrenched in a crisis-induced recession while Japan was recovering from the nuclear meltdown, it was up to the US to pick up the slack. Even China, which was supposed to be the growth engine of the world struggled as reforms slowed down the manufacturing sector. Today, Europe is beginning to be seen as a positive contributor to global growth.


In the recently released World Economic Outlook by the IMF, economic growth forecast for Europe has been revised upwards (Figure 2). This is not surprising as recent economic data has been improving. Germany’s ifo business survey result has been positive, especially when it comes to meeting expectations. This favourable result was also confirmed by the wider eurozone economic sentiment indicator (Figure 3), which saw sharp improvement in business confidence. Although the employment picture in the EU remains grim, with the current unemployment rate at 11%, those who have jobs are loosening their purse strings. Retail sales, while contracting year-on-year, are doing so at a slower pace (Figure 4). As the economy improves and confidence rises, retail sales are expected to start growing again, creating a sustainable demand for goods and services in the eurozone. This has the potential to start a virtuous economic cycle.

Figure 2: Germany’s ifo survey is positive on the business outlook

Figure 3: EU economic sentiment recovering sharply

Figure 4: Eurozone retail sales edging towards expansion

The market has not lost out on these developments. European equities have been rallying since mid-2012 and have recently begun to outperform US equities three months ago. Troubled economies like Spain (Figure 5) and Italy (Figure 6) are also seeing some strength in their equity markets, breaking out of their year long trading range. Our favourite European chart (Figure 7) of comparing financials to the market, continues its march upwards. Besides reducing the odds of a break up of the eurozone, the outperformance by European financials continues to point towards economic growth in the eurozone. The strong signals in European markets suggest to us that the ongoing recovery in the eurozone looks sustainable. This is another bullish signal for global growth.

Image courtesy of Stockcharts.com

Figure 5: Spanish equities breaking out of trading range

Image courtesy of Stockcharts.com

Figure 6: Same for Italian equities

Image courtesy of Stockcharts.com

Figure 7: European financials continue to outperforms


Japan is another misunderstood economy, where the recently passed consumption tax overshadowed positive developments in the economy. Consumer confidence (Figure 8) has been rising since Abenomics started to show initial signs of success. Machinery orders, a key indicator of corporate Japan, have expanded for consecutive months (Figure 9). Manufacturers are also more upbeat about business prospects, with the Tankan survey at levels not seen since 2007 (Figure 10).

One reason why business activity is on the rise is the weakness of the yen. Unprecedented level of quantitative easing by the Bank of Japan has pushed the yen up from 80 to around 97. That a 20% depreciation in a matter of six months and should be seen as a 20% increase in Japanese competitiveness. Our view is that so long as the yen holds the 95 level against the US dollar, Japanese earnings can continue to support equities, at least till the early part of next year. After that, we really do need to see substantial reforms from the Abe government to unleash economic potential. If not, chances are that the Japanese business cycle will slow. Currently, according to the OECD composite leading indicator, Japan's economic growth continues to be above trend. To keep the momentum going, more needs to be done by Prime Minister Abe, and this is a key factor long term investors in Japan need to watch out for. Nonetheless, the current economic momentum is strong in Japan.

Figure 8: Consumers are more confident

Figure 9: Expansion in machinery orders more durable

Figure 10: Corporate outlook has improved successively

United States

Economic growth in the US has been resilient, but that is now thrown into question as the government shutdown appears to show no sign of ending, as of the time of writing. Also, with the debt default used as a bargaining chip in political negotiations, uncertainty has risen not just in financial markets but also among businesses and consumers. Furthermore, market breadth, as measured by the number of stocks trading above the 200-day moving average (Figure 11), has weakened considerably since May. It would thus seem logical that investors should exercise caution, at least with the US market that has risen 19% year to date.

However, digging deeper into the market explains why market breadth has been weakening amidst a rising stock market, which has been a considerable source of frustration for some investors. Defensive sectors like staples and utilities have been struggling since May. On an absolute basis, staple stocks are trapped in a trading range (Figure 12) while utilities have been trending downwards (Figure 13). On the other hand, economic sensitive cyclical stocks have risen over the past six months (Figure 14). This shows that the current deterioration in market breadth is a result of investors rotating out of defensive, high yielding stocks, into cyclical stocks that are tied more closely to economic activity. This is why we are giving the weakness in market breadth a huge benefit of doubt, expecting it to recover once investors are done with rotating out of the defensive sectors.

Image courtesy of Stockcharts.com

Figure 11: Market breadth has weakened

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Figure 12: Staples struggling nowhere

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Figure 13: Utilities are trending down

Image courtesy of Stockcharts.com

Figure 14: Cyclicals in a bull mode

Regarding the potential debt default by the US, we find that bonds are also holding up much better than equities. Since the government shutdown and the political impasse, we see high yield and emerging market bonds rallying, even as equities entered a volatile period (Figure 15), depending on whether the parties were talking to each other or not. This is another reason why we think the market is discounting a quick resolution to the current debacle, even in the worst case scenario where a technical default occurs but is subsequently resolved as both parties compromise.

Figure 15: Bonds doing better than equities since shutdown


Investing has and will always be about taking and managing risk. There has never been a time when investors have faced a risk-free future. Yet, considering the fact that currently the major economic blocs are all growing at the same time and the positive impact on earnings. As well as how markets are positioning themselves in light of these “catastrophic” risks, we thus find it illogical to turn defensive so long as the signs remain positive. Hence we continue to maintain a bullish view on risk assets, especially developed market equities.

Portfolio Positions

We will continue to maintain our current equity positions and ride out the current volatility. No changes are recommended at this time.

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