14 October 2014

Macro Strategy Update

The Big Picture

Executive Summary: The story of the economic recovery in the US continues to be supported by fundamental data. The Eurozone has printed weaker numbers in the past two months and it appears that growth is stalling. Data coming out of Emerging markets and Asia have also been mixed. Despite the sell-off over the past two weeks, financial stress indicators are not showing increased tail risk to equity markets just yet. As such, we remain confident of the US market and neutral on other markets until the narrative changes.

Portfolio Positions: We will be removing our European weights to reallocate to US Large Caps. In addition, we could possibly initiate a slight equity underweight in the event that markets continue to sell-off and financial stress indicators trend negatively. We will be sending out our recommendations in a separate notification.

Article

Introduction
Autistic British architectural artist Stephen Wiltshire is renowned for his ability to draw panoramic images of entire cities from memory following a brief helicopter ride. He was in Singapore recently to draw a panorama of the country. His ability to recreate large landscapes is amazing, but the minute details he accurately sketched was even more astounding. Conversely in the investment world, we sometimes get caught up in the small details from daily market movements and news flow, and miss the forest for the trees. The recent global sell-off has triggered more volatile market activity, which would have made most investors nervous. Rather than panic, let’s look deep into the market for signs that may prove our bullish call wrong.

European Weakness
What is clear is that European fundamentals have been slowing down over the past two months (Fig 1). There has been a slew of disappointing data coming out of Europe. Germany, the economic powerhouse of the Eurozone, appears to be sputtering. Exports out of the world’s fourth largest economy were down 5.8% in August, the biggest monthly decline since the last recession. PMI numbers for manufacturing fell below the 50 level, indicating contraction. Ifo business climate index continued its downtrend, the fifth successive lower reading. All these have prompted the IMF1 to double the odds that the Eurozone will re-enter a recession to 38%.

Fig 1: Composite PMIs Comprising Manufacturing and Services Indicate a Slow Down.

ECB QE Program
With the risk of a European recession and deflation growing, there have been increasing calls for eurozone governments to stimulate their economies, the odds are rising that Germany will begin to loosen up the purse strings. In addition, the ECB announced in early September to begin on a form of quantitative easing through the purchase of ABS and covered bonds, together with the ongoing bank lending program. The European market, especially the larger cap indices are slightly negative on a year to date basis in Euro terms. However, it feels much worse as the Euro has depreciated against many currencies, exacerbating losses. When we check economically sensitive sectors like financials, despite suffering a corrective phase with the rest of the market, they are actually outperforming on a relative basis (Fig 2).

Image courtesy of Stockcharts.com

Fig 2: European Financials Outperforming the Market Since Aug.

Global Outlook
When we look at the world in overall, fundamental data supports a slow growth environment supported by the recovery of the US economy (Fig 3). Chinese manufacturing data has stabilised and the central government is committed to support growth through easing. Japanese data has bottomed and it appears that it will pull out of its sales-tax induced slump.

Fig 3: Global Composite PMI Has Ticked Down But Is Still Expansionary

US Capital Expenditure.
In the US, there has been a shift to capital expenditure and investment for corporates, which had stalled somewhat in the last two years (Fig 4). This is favourable as it means that real GDP growth can continue, and if it can lead to higher productivity, earnings growth can be maintained. Commercial lending has also picked up year-to-date and is important to gauge business confidence and is closely linked to capital expenditure (Fig 5).

Fig 4: Higher Investment by Businesses is Positive For the Economy.

Fig 5: Commercial Loan Growth Is Linked To Capital Expenditures.

US Market Conditions.
Since the end of Aug where retailers began reporting earnings surprises, we began to see outperformance of retailing stocks on a relative basis. Having underperformed the broader market since the beginning of the year, it is an encouraging sign and directly correlated to consumer confidence and expenditure (Fig 6). There is also some negative data to consider. The NYSE Bullish Percent Index, which measures the percentage of stocks that are exhibiting bullish trend, has plunged below 50% (Fig 7). This means more than half the stocks trading on the New York Stock Exchange are in a bear market. This may sound alarming, but some context is necessary. The last time this occurred was in June 2012. Back then, against the backdrop of a potential US default and weak fundamental data, the S∓P500 suffered a 10% correction but recovered and went on to collect a 50% gain over two years.

Image courtesy of Stockcharts.com

Fig 6: Retailers relative to Market.

Image courtesy of Stockcharts.com

Fig 7: NYSE Bullish Percent Index.

High Beta Sell-Off
Breaking down the market shows that certain sectors like small and mid-cap stocks, energy and the NASDAQ have suffered more than others. The energy sector has been pummelled by weak Brent prices and is now in bear territory (Fig 8), whilst the Russell 2000 index has breached support levels (Fig 9). Elevated valuations for small and mid-cap stocks have led investors to reposition their portfolios and take profits off the table.

Image courtesy of Stockcharts.com

Fig 8: Energy Sector Market Breadth at Extreme Low Levels.

Image courtesy of Stockcharts.com

Fig 9: Investors Have Sold Out of Small and Mid Caps.

Financial Stress Indicators
We will also have to check whether there are financial market stresses which could imply a large tail risk for equities. In such conditions, the probability of a large correction rises significantly. Spreads, whilst up slightly from their lows, have not spiked significantly which implies fear or a lack of liquidity in the system (Fig 10). Despite the recent sell off in high yield bonds, the spread when viewed in a long term context does not show a large scale flight to safety (Fig 11). The St Louis Fed Stress Index which is an amalgamation of 18 difference financial market stress indicators does not show instability and whilst it has risen, it is nowhere near levels where investors should begin to worry, let alone panic (Fig 12).

Image courtesy of Stockcharts.com

Fig 10: TED Spreads Do Not Indicate Increased Credit Risk.

Fig 11: High Yield Bond Spreads Do Not Show Increased Default Risk Either.

Fig 12: The STLFSI Is Rising, Albeit From Extremely Low Levels.

Conclusion
Despite the seemingly unending sell-off over the past two weeks, markets in general are 5 to10% from their highs. We remain cognisant that the selling could continue for a while longer, tipping the market into a full-fledged correction. Corrections have always been a feature of all stock market rallies and so long as the market’s preference for risk taking remains intact, investors should remain buyers of the market. Looking past the short term volatility and at the bigger picture, fundamental data supports the US recovery. We remain confident of the US market and neutral on other markets until the narrative changes. Our view will be reflected in our portfolio positions.



References
1. IMF Cuts 2015 Global Growth Forecast to 3.8%. 7 October 2014 The Wall Street Journal

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