15 August 2014

Macro Strategy Update

A Fundamental and Technical Collision

Executive Summary: The recent sudden sell-off in markets at the end of July to early August occurred in the midst of a decent earnings reporting season in the US and also on the back of encouraging fundamental data. As the data did not suggest anything untoward with the economy, the decline could probably be explained by technical analysis. We are of the view that unless there is a fundamental bearish trigger, any technical decline in the markets would likely be temporary. As such, we continue to remain confident of the global recovery, but remain flexible to change our views if necessary.

Portfolio Positions: We continue to remain neutral in our asset allocation and would not overweight any risk assets at this point in time. We currently have an overweight to developed markets.

Article

Introduction
The Large Hadron Collider is the world’s most powerful particle collider built by the European Organisation for Nuclear Research. The project took 10 years to complete and lies in a tunnel 27 kilometers in circumference buried 175 meters underground in Switzerland. Its purpose is to collide two opposing particle beams to study different theories of particle physics. The recent sudden sell-off in markets at the end of July to early August occurred in the midst of a decent earnings reporting season in the US and also on the back of encouraging GDP numbers. Fundamentally, as the data did not suggest anything untoward with the economy, technicals could probably explain why the decline happened. When fundamentals and technicals clash, typically fundamentals win but let’s look at the data to form a basis for our conclusion.

Global Growth Prospects
Developed market growth is on a positive trend, led mainly by the US (Fig 1). We remain cognizant of the fact that within developed economies, the Eurozone and Japan have slowed down in recent months, which could be due to the overall slower outlook for 2H 2014. Growth prospects for emerging economies whilst expansionary, remain slightly lacklustre, compared to the previous cycles (Fig 2). International bodies like The World Bank and the IMF have reduced medium term growth projections for developing economies, citing structural issues like supply side constraints and tighter domestic financial conditions.

Fig 1. Global Composite PMI Remains Positive

Fig 2. EM PMIs Have Slowed Down Slightly But Are Still Expansionary

Continued Revenue Growth
The fundamental underpinning to a bull market is rising earnings which are driven by rising revenues. As the bigger S&P 500 companies tend to do more business globally, the recent earnings season has shown that despite the slower growth in the global economy, it is sufficient enough to propel earnings and revenues of these multinational companies higher (Fig 3).

Fig 3. Rising Sales Drives Revenues Which In Turn Drives Earnings

Chinese Growth Stabilising
After three years of slowing growth, a small turnaround in second quarter GDP growth and better than expected July PMI number caused a shift in investor sentiment. The change in attitude sent the Chinese stock market soaring after going nowhere since the start of 2014 (Fig 4). The influence of the Chinese economy on global growth and especially Asia is strong. The recent mini-stimulus measures implemented by the central government have propped up investor sentiment. There is growing optimism that the world’s second largest economy can avoid a hard landing and in addition to the surge in the Shanghai stock exchange, industrial metal prices which are correlated to Chinese growth have also staged a small rally since late Mar (Fig 5).

Image courtesy of Stockcharts.com

Fig 4. Chinese Equities Breaking Out of its Wedge Pattern Which Implies Bullishness

Image courtesy of Stockcharts.com

Fig 5. Industrial Metal Prices Have Recovered

Interest Rate Headwinds
Rising interest rates in the US will likely cause short term volatility in the markets, as what we saw in mid-2013. In the longer term it is good for markets as it implies that growth is back underway. However, the short term fears that the Fed may raise rates prematurely has dissipated somewhat and it is likely that rates will consolidate around the current level. One of the indicators that the Fed keeps close tabs on is the housing market in the US, and for the time being this sector remains weak and is a drag on the economy. The growth momentum in housing starts (Fig 6) and new home sales has sputtered as affordability (Fig 7), whilst better than pre-crisis, has come off its lows since 2012. The weakness in housing is also seen through weak homebuilder stocks (Fig 8). It is thus unlikely that the US economy will surprise to the upside beyond the third quarter. As a result, interest rates, which have been drifting lower since the start of the year, is unlikely to see any significant rise for the rest of the year.

Fig 6. The Rate of Change of Housing Starts is Tapering Off


Fig 7. Affordability Has Dropped Although It is Slowly Creeping Up Again


Image courtesy of Stockcharts.com

Fig 8. Homebuilding Stocks Have Struggled

General Risk Aversion
Given the generally positive data thus far, what would we make of the recent sell-off then? The geopolitical crisis in Ukraine had been brewing for several months, and the effects were seen in the Ukrainian and Russian markets but nothing suggested that contagion would spread to the other parts of the world. The Iraq and Gaza crisis was also localized and whilst there was a possibility of a spike in energy costs, we argued in our previous update that oil supply would not be unduly affected. What we saw was a general risk aversion which started with a sell-off in high yield fixed income products (Fig 9). Given that the economy was growing and with interest rates set to remain low, there was no particularly good reason for the outflows except for profit taking on what had become an extremely crowded trade. The performance of small caps relative to their large cap counterparts have also resumed their downtrend in both the US (Fig 10) and the rest of the world (Fig 11) following a brief rally since mid-May to June.

Fig 9. High Yield Sell-Off Led by ETFs


Image courtesy of Stockcharts.com

Fig 10. US Small Cap Continues Its Underperformance in July

Image courtesy of Stockcharts.com

Fig 11. Small Cap Underperformance is Also Similar for Europe, Asia and the Far East

Conclusion

In past episodes of conflicting signals from both fundamental and technical indicators, fundamentals always won in the end. Global growth is not as high as what investors would like, and there are still problems in pockets of the world, but we are in a much better place than the previous few years. However, given the divergence that we are seeing, we have to remain on our toes and monitor the data carefully. We are of the view that unless there is a fundamental bearish trigger, any technical decline in the markets would likely be temporary. As such, we remain neutral in our asset allocation and would not overweight any risk assets at this point in time.



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