11 December 2013

Macro Strategy Update

Reviewing 2013

December is usually a good time to take stock and review the market calls we made at the beginning of the year. Back then, we were bullish, expecting another positive year for risk assets. Barring any major shock to financial markets over the next three weeks, 2013 is turning out to be a rather good year for risk taking. And this is notwithstanding the many challenges like the Cyprus bailout, uncertainties over the Fed’s tapering and of course, the potential US debt default that threatened to bring down capitalism. Despite the strong performance by equities, the disparity in returns among various markets offers lessons for investors as we head into 2014.

Back in January, we had a bullish view on the fact that the global economy was picking up, European woes were easing and G3 central banks was expected to continue their loose monetary policy. Our concern for the year was mainly the elections in Germany, which had the potential to upset the stability provided by the ECB and send investors running into safe haven assets.

While we were right on economic growth, we were initially wrong in making the case for overweighting emerging markets (which we corrected in May). By May, it became clear to us that investors were getting more selective, preferring developed markets over emerging markets. Economic growth in developed economies were surprising to the upside while emerging economies struggled with inflationary concerns. By the time tapering became a buzzword, the disparity between developed and emerging markets equities had increased significantly.

One of the arguments for buying emerging market equities, especially after the mid-year sell off was the value they offered. Back then, emerging markets were trading at a discount to developed market equities. It would seem to be an attractive opportunity, given the strong long term fundamentals that many associate with emerging markets. However, the prospect of slowing growth, coupled with continued liquidity outflows began to make the case for emerging markets less appealing. As seen from Figure 1, since the start of the year, developed equities outperformed emerging market equities by a massive 28%. By October, it became obvious that the emerging world was grappling with slower growth as the IMF cut the emerging world’s growth forecast for 2013 and 2014. The value proposition offered by emerging markets turned out to be a trap.

Image courtesy of Stockcharts.com

Figure 1: Developed markets outperforming emerging markets

Another lesson we can learn from 2013 is that the business cycle matters more than politics, especially in a free market economy. Despite the two-week Federal government shutdown in October that almost threatened a debt default by the world’s largest debtor (the United States), markets were able to shrug off the worries and run up higher as seen in Figure 2. As recent data has shown, the US economy continues to grow despite the disruption from the political gridlock. Government shutdowns grab headlines, but investors would be better served paying attention to how the economy was performing and what the market is signalling.

Image courtesy of Stockcharts.com

Figure 2: US equities powering ahead despite a government shutdown

Of late, some of the market signals that we track have been flashing warning signs. The underperformance of US financial and housing stocks, the widening of credit spreads and the resumption of a rise in US Treasury yields (Figure 3) are pointing to a challenging time as we enter 2014. Given how strong cyclical and consumer stocks are performing, we remain convinced that the odds of a recession in 2014 are low. However the expected rise in interest rates could be a catalyst for investors to take profit in 2014. Higher interest rates act as a hurdle for credit based consumption and investment, and could trip the economy unless growth comes in stronger to compensate. As such, paring down portfolio risk makes sense given the current strong run up in global equities even as the number of stocks participating in the rally continues to lessen (Figure 4).

Image courtesy of Stockcharts.com

Figure 3: US Treasury yields are rising again

Image courtesy of Stockcharts.com

Figure 4: Market breadth has weakened

In conclusion, we see the bull market in global equities continuing in 2014. However, the improvement in developed economies means a change in monetary policy is likely in the offing. Markets have always had a difficult time adjusting to change, so we suspect the new year will be volatile, as investors try to get ahead of central bankers while the latter attempt to telegraph their intentions without upsetting markets. Another likely scenario for 2014 would probably be the dichotomy between the economic and monetary policies among the different economic blocs. The Fed looks set to ease off monetary stimulus on the back of a stronger economy, while the ECB struggles with low economic growth that could tip back into negative territory. Meanwhile, emerging economies are likely to continue purging the excesses built up over the past few years. As such, 2014 is set to be an eventful year for investors. Watch this space!

Portfolio Positions

With the strong momentum in the developed markets & Japan, we have decided not to change our portfolio positions as yet. However we are positioning for the eventual correction and will be sending out our switching recommendations in the next few weeks.

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