27 February 2014

Macro Strategy Update

A Weaker High

Executive Summary: The recent bounce from January’s lows appears to be weaker than it seems. There has been some damage to the market psychology from the depth and speed of how markets corrected. Whilst major US and European indices have recovered their recent losses, many markets such as Japan, Asia and Emerging Markets are still trading below Dec 2013 highs. We continue to see negative signals and weak market breadth which makes us wary of the current rally, and the probability of a more significant correction remains high.

Portfolio Positions: Unchanged as per our last update. We are awaiting an opportunity to adopt developed market overweights 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.

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Weak Breadth
Our signals continue to point towards caution and risk appetite looks unlikely to improve in the near future. Market breadth remains weak, despite the S&P500 recovering its recent losses (Fig 1). The percentage of S&P500 stocks trading in a bullish trend remains markedly lower than the start of the year.

Image courtesy of Stockcharts.com

Fig 1: Breadth Is Weaker Despite The Market Recovery

Financials and Yield Spreads
Financial stocks have underperformed the broader market since the start of the year, continuing the trend since the middle of last year (Fig 2). This could indicate a market topping process. The spread between CCC- and BB-rated bonds continues to increase (Fig 3) indicating investor preference towards less risky high yields and a lower risk appetite tolerance.

Image courtesy of Stockcharts.com

Fig 2: Financial Sector Continued Underperformance

Fig 3: Widening Credit Spreads

Japan and Currency
One of our favorite markets appears to be struggling again. While this is largely in line with the weakness that we see in global equities, there is concern that Abenomics has fizzled out and Japanese equities will disappoint again. The rising current account deficit, due to increased import costs of energy, is threatening to derail economic prospects in Japan. Nonetheless, Japan is likely to return to a current account surplus once nuclear power production is resumed. Press reports indicate that Japan is poised to make a U-turn on its nuclear policy, where all nuclear power plants were shut down after the Fukushima tragedy. Once nuclear power is restarted, Japan’s energy imports will fall and the current account deficit will become less of an issue for investors. Lower energy costs will also be a boom for corporate Japan as the earnings momentum is likely to be sustained. In the short term, the yen continues to drive equity performance in Japan. Despite the twenty odd percent decline in the Japanese yen against the US dollar, the yen is still trading at levels last seen during the 2008 financial crisis (Fig 4). Strategists are expecting the next target for the currency to be 110. This will help boost the Japanese equity markets but will require more monetary stimulus from the Bank of Japan, or an improvement in global risk appetite.

Fig 4: Japan Yen versus US Dollar



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