14 January 2014

Macro Strategy Update

2014 Investment Outlook: The Tension Within

Executive Summary: We remain bullish on developed market equities in 2014, on the basis that earnings will catch up with valuations, and with the highly accommodative policies of both the ECB and BOJ. Emerging markets will continue to struggle with economic adjustments, a strengthening US dollar and a weak commodity market. We are mindful that rising interest rates affect valuations and could temper market optimism – with a choppy investment environment as a by-product. Strap yourself for the volatility but expect rewards at the end. For more details, please see the in-depth article below.

Portfolio Positions: Our outlook is reflected in our positions where we will be reducing equity allocations to park in short-duration bonds in the short term, to pre-empt and take advantage of a possible correction in the market. We will be sending out a rebalancing recommendation this week.

Article

Overview
We ended 2013 saying that we see a continuation of the bull market that started in March 2009. This year, as more data suggests a stronger global economy, and as more observers upgrade their economic outlook for the world, it is natural that investors turn more bullish. Wall Street strategists are predicting another positive year for the S&P500, money managers are touting equities as the preferred asset class and investors are buying into the story. Whilst we are still positive on markets, we believe it will be a challenging 2014 as the struggle between higher earnings growth and higher interest rates could cause markets to labour.

US Growth Estimates To Be Raised
With the strong outperformance by cyclical stocks late last year, we said that economic growth could surprise on the upside in 2014. On Jan 7 2014, the head of the IMF indicated that global growth will be raised as the outlook of the US economy improves1. We suspect they will not be alone in revising growth outlook as the economic momentum builds in the US; raising confidence, consumption and capital investment.

The US Economy Will Accelerate In 2014
Growth in the US continues to come from various sources. Businesses are spending and hiring, seen from rising fixed investment (Fig 1) and strong demand for labour (Fig 2). This results in rising income and consumption until inflation forces the Fed to cool growth. The fact that cyclical stocks have outperformed the broad market by 8% in 2013 (Fig 3), indicates that economic growth will surprise to the upside this year.

Fig 1: Private Non-Residential Investment Has Been Rising

Fig 2: Labour Demand Has Been Healthy

Image courtesy of Stockcharts.com

Fig 3: Cyclical Stocks Outperforming the S&P500 in 2013

Long Term Trends Provide An Economic Tailwind
Besides cyclical forces at work, long term factors provide a tailwind for the US economy. Manufacturing is starting to return to the US after years of offshoring as labour cost is no longer an attractive selling point for emerging economies. Another trend change for the US economy is that the deleveraging of US consumers is probably over, and credit driven economic growth is likely to return. The contraction in household liabilities has ended and we have the first uptick since Q3 of 2008 (Fig 4). These signs bode well for the US economy in 2014.

Fig 4: Households Borrowing Again in Q3 2013

Employment Trends Remain Positive
December's US jobs report may have been very weak, coming in at 74K which is below 2013’s average of 185K jobs per month. A single data point does not mean a trend. Cold weather may have been a factor for the decline in employment, and the job picture should improve as the weather gets balmier. Furthermore, the trend in temporary help services, a leading indicator of labour market conditions continues to rise (Fig 5).

Fig 5: Demand for Temporary Help Remains Robust

Better Growth Rates Not Necessarily Better For Equities
Higher economic growth is usually positive for equities as it translates to higher earnings. However, investors need to remember that interest rates are now rising, and that will affect equity valuations. The idea that interest rates are on a secular uptrend is gaining traction and this is putting downward pressure on valuations. Since the outgoing Fed Chairman’s suggestion of reducing the amount of bond buying in May 2013, interest rates have been trending higher. The US 10-year Treasury yield is now 3%, up from a low of 1.6% in mid-2013 (Fig 6).

Image courtesy of Stockcharts.com

Fig 6: US 10-Year Treasury Yields Have Doubled

Rising Rates = Volatile equities
While some observers highlight that monetary policy is still loose despite tapering and the Fed has said that rates will remain low after the QE program ends, it is a fact that interest rates have been rising and that is a form of monetary tightening. Historically, when the Fed tightens, equities struggle. The S&P 500 was volatile in 1994 and 2004 (Fig 7) when the Fed began to tighten monetary policy. Equities began to rise only after interest rates stabilised.

Image courtesy of Stockcharts.com


Fig 7: Performance of S&P 500 in 1994 and 2004

Earnings Surge May Not Ignite The Stock Market
In both 1994 and 2004, there was an earnings surge (Fig 8) which failed to ignite the stock market. The second quarter of 1994 saw a doubling in earnings growth as the US economy picked up momentum. This was enough for then-Fed chairman Alan Greenspan to act, surprising markets with the first of a series of tightening moves. A similar earnings environment occurred in 2004 when earnings growth jumped from 28% to 77% in Q4 of 2003. Consensus estimates for 2014 show an accelerating US economy and a jump in earnings growth. However, rising interest rates could keep a lid on the stock market and with 10-year Treasury yields resuming its uptrend, the risk for equity investors is that rates are too high for the economy to handle.

Fig 8: S&P Earnings Growth in 1994 and 2004

Loose Policy From ECB Supports European Assets
Unlike the Fed, the ECB looks unlikely to tighten monetary policy soon, given that the Eurozone continues to flirt with deflation. Core inflation which excludes volatile items like food and energy, slowed to 0.7% in December, the lowest since the series was created. There is a growing concern among some in the ECB that Europe may slip into a Japanese-style deflation. Nevertheless, European economic confidence continues to improve, with consumer and business sentiment rising (Fig 9). For the last quarter of 2013, the Eurozone manufacturing PMI recorded its best performance in two-and-a-half years. European equities can potentially enjoy rising earnings growth with stable or higher valuations, making them a prime candidate for asset allocators.

Fig 9: Confidence Rising Amongst Europeans


The Yen Remains The Key Driver Of Japanese Equities
After a 49% rally in 2013, Japanese shares have been touted by strategists to return another 16% this year2. Japanese equity performance has been positively correlated to yen weakness. The Third Arrow from Prime Minister Shinzo Abe remains vague and investors are no longer counting on structural reforms to push the market higher, hence the need for the yen to depreciate more. From a technical and historical perspective, there is still room for the yen to fall. Divergent monetary policy between the US and Japan, and a widening interest rate differential between both countries’ bonds should send the yen lower and Japanese stocks higher, so long as the BOJ remains accommodative.

Image courtesy of Stockcharts.com

Fig 10: The Yen Can Weaken Further

Not Time For Emerging Markets To Outperform
Economic adjustment takes time, and it is likely that the underperformance by emerging market equities will continue in 2014. China’s growth is unlikely to surge as the leadership has chosen to focus on restructuring the economy and strengthening the Communist Party, instead of targeting a higher level of GDP growth. Ramping up industrial activity in the world’s second largest economy is also tempered by environmental concerns. As such, economic activity in China will either stabilise at current levels or ease slightly. This has been reflected by the weak performance of the Chinese equity market (Fig 11) and the lacklustre showing by commodities (Fig 12).

Image courtesy of Stockcharts.com

Fig 11: Chinese Stock Market Has Languished Since 2009

Image courtesy of Stockcharts.com

Fig 12: Commodities Have Struggled Since 2011

Conclusion

As asset managers, we are not in the business of making predictions but to identify risk and manage the potential downside. As far as we are concerned, forecasts serve as a guide but are not a means to an end. As such, listening and monitoring the market is our preferred approach to making investment decisions. We remain bullish on developed market equities in 2014, on the basis that earnings will catch up with valuations, but suspect that it may be a struggle at least in the early part of the year. Stock markets are unlikely to stage a strong rally until investors are comfortable that interest rates are not too high for the economy, or until interest rates stabilise. Strap yourself for the volatility but expect rewards at the end.



References
1. IMF Plans to Raise Global Economic Growth Forecast, Lagarde Says. 7 January 2014 Businessweek
2. Japan World-Beating Stocks Seen Repeating Gains in 2014. 27 December 2013 Bloomberg News

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