12 February 2014

Macro Strategy Update

It's Just A Correction

Executive Summary: Markets are struggling to gain a footing after a volatile start to the year. The media has been quick to play up the doom and gloom and foretell worse things to come. Let’s look past the noise and focus on where the markets are likely to be in the next few months. Whilst Emerging Market problems continue to hog the headlines, developed market economic data and signals continue to be positive. As such, we view markets positively and see the recent falls as just a bull market correction.

Portfolio Positions: We are seeking opportunities to adopt a developed market overweight within our equity allocations for clients holding higher short-duration bond positions. Clients currently holding neutral or equity overweight allocations will be rebalanced once market conditions are favorable.


The recent sharp decline in equity markets around the world has left investors worried that the bull market is over. Emerging market problems continue to remain at the fore, adding to worries that a contagion may spread to the developed economies. We have warned about a correction for the last two months. Our view remains unchanged and we see the recent falls in stock markets, especially in developed regions, as just a bull market correction.

Global equities have corrected around 6% since the second half of January (Fig 1) while emerging markets have given up another 8% since the start of 2014 (Fig 2). Emerging world events appeared to have triggered the selling. China’s weak manufacturing numbers, Argentina’s decision to not defend the peso, and continued political turmoil in some emerging countries were sufficient reasons to spook investors. According to EPFR Global, year to date fund outflows from emerging markets stands at US$18.6 billion, compared to US$15.2 billion for the whole of 20131. Developed equity markets were also hit by outflows from stocks into bonds.

Image courtesy of Stockcharts.com

Fig 1: First Significant Correction Since June 2013

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Fig 2: EM Continues The Decline

Unforeseen? Probably Not
It is worth noting that none of the news was actually new. China’s economic slowdown and the emerging market capital flight as a result of Fed tapering have been reported for months. Although the recent behaviour of major indices seems to suggest that the market is anticipating something new, it is likely that markets are just undergoing a healthy correction having chalked up solid gains in 2013. Corrections are part and parcel of any healthy bull market as it allows fundamentals to catch up with stock prices. From market signals and indicators, there are insufficient negative ones to justify making a bear market call. However, we must be mindful that there are possibilities of negative surprises like the Fed suddenly cutting back on bond purchases, but fixed income markets have not priced it in. US ten-year yields did not convincingly break out of the last high in early September last year (Fig 3).

Image courtesy of Stockcharts.com

Fig 3: Rise In Ten-Year Yields Losing Momentum

Economic Momentum Continues
Economic momentum in the US is likely to continue and investors’ preference for economic-sensitive stocks remained unchanged. For the US, the cyclical (Fig 4) and consumer discretionary (Fig 5) sectors continue to outperform relative to the broader market. Importantly, we also see some signs of stability in the housing sector (Fig 6). Housing is an important component of the US economy, from homebuilders and housing related industries to consumer sentiment linked to household wealth.

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Fig 4: Cyclical Stocks’ Relative Outperformance

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Fig 5: Consumer Discretionary Stocks Are Still in an Uptrend

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Fig 6: Housing Stocks Look Set To Outperform The Market

Positives From Europe
Europe is doing well, as shown through the strong Jan 2014 PMI from the euro zone (up to 54 from 52.7 in Dec 2013) which confirms that the recovery is gaining momentum. Even Greek manufacturing PMI is in positive territory, having languished in contraction zone since August 20092. Meanwhile, the legal hiccups with the ECB’s Outright Monetary Transactions program has yet to make an impact on markets as European bond yields continue to fall and the euro holds on to its 2013 gains. Investors’ confidence in the euro zone is also reflected from the strength in European financials (Fig 7).

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Fig 7: Investors Continue To Prefer Financials In Europe

Emerging Market Weakness
Meanwhile, EMs continue to struggle although a short term bottom looks to be forming. Amidst the slew of negative news and sentiment, we assess that the risk of a full blown financial crisis is on the low side. Unlike in the 1990s, EMs with open capital accounts have currencies that are free floating. This reduces the odds of a shock to the economic system as free floating currencies act as a pressure relief valve, allowing the economy to adjust to changing economic conditions. In addition, EM reserves are in a much better position than in the previous Asian financial crisis (Fig 8). The fact that emerging market bonds have stabilised probably strengthens our case (Fig 9). What is certain is that EMs will be saddled with slower growth, or maybe even a recession for some of these economies.

Fig 8: EM Reserves Have Risen Significantly

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Fig 9: Some stability in EM bonds

1. Fund flow from emerging markets clear 2013 level. 7 February 2014 Gulfnews
2. Greece manufacturing sector growth boosts eurozone recovery hopes. 3 February 2014 The Guardian

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