14 November 2014

Macro Strategy Update

Warm Porridge

Executive Summary: The world appears to be headed to a positive but slow growth environment. On a relative basis, some countries like the US, China and the Asia-Pacific region appear more positive from a fundamental and economic basis. The end of QE in the US is not a game-changer as lending conditions are on a much better footing. In addition, the ECB and BOJ are embarking on their own versions of easing, which will continue to supply financial markets with liquidity. Seasonal factors could drive equity markets to a nice finish in 2014 and we want to stay invested until data points change.

Portfolio Positions: We have recently executed our overweight positions to the US market for most portfolios during the recent correction in Oct. We want to sell into strength and reduce this overweight latest by end-Jan 2015. We will be sending out our recommendations soon.

Article

Introduction.
Goldilocks and the Three Bears is a fairy tale which originated in the mid-1800s. In the story, the antagonist tries out each of the bears’ chair, bed and bowl of porridge, always preferring the one which was ‘just right’. In essence the global economy at this stage is just like the porridge Goldilocks liked. Not so hot that inflation is prevalent and not so cold that it causes a recession. That said, there are countries and regions which are likely to do better than others in the present environment as the world experiences divergent growth.

Global Growth.
Global coincident and leading indicators point to a slower but possibly more stable growth environment (Fig 1). Whilst there are fresh signs of weakness in Europe and some of the commodity producing countries, broad-based growth is evident amongst many countries. The US continues to show economic strength, with economic and fundamental data at levels not seen since the peaks before the financial crisis. Europe is mixed, with the peripheral countries showing signs of recovery whilst the economic powerhouse Germany is slowing down. In Emerging Markets, China and India are showing signs of economic stabilisation and a potential turning point in their economies.

Fig 1: Overall Global PMI Expansionary And Should Settle Into A Moderate Growth Level.

Better Lending Conditions.
Much has been said about how the Fed’s money printing artificially boosted asset prices and did not trickle into the real economy. However we can agree that this unprecedented stimulus possibly staved off a deeper recession in the US and enabled the economy to get through a painful deleveraging process. The big difference with the end of QE3 to QE1 & 2 is that financial conditions including credit spreads and lending are on a much better footing than in the past (Fig 2). The fear that affected the markets when the previous money printing iterations ended was not seen this time round. In any case, whilst the US is ending QE, the Bank of Japan and the ECB are embarking on new rounds of it ensuring a continuous stream of liquidity in the world’s financial systems.

Fig 2: The Chicago Fed’s National Financial Conditions Index Does Not Show Tighter Lending Standards At The End of QE3 Compared To QE1 & 2.

US Coincident Economic Indicators.
The fundamental backdrop remains supportive for higher highs in the US equity market. We look at the index of Coincident Economic Indicators to gauge the strength of the economy. These indicators measure real time economic activity with components of payrolls, real income, industrial production, manufacturing and trade data (Fig 3). Thus far, there are no signs that the economy is heading south and as such, we remain confident of the US.

Fig 3: The Ned Davis US Economic Continues To Show Strength In the US Economy.

Valuations of the US Market.
Depending on whom you speak to, or which newspaper you read, the views on US market valuations ranges from fairly valued to bubble territory. What is certain is that equity market will depend on company earnings to come through in order for it to continue to new highs. The real question is whether companies can continue to make money and we are confident that they will. During this last business cycle, US corporates have become much more efficient and learnt to do more with less (Fig 4). With corporate earnings growth estimated to hover within the 8-10% level, we expect the US equity market to continue its positive trend.

Fig 4: Bigger Companies Have Been Consistently Expanding Margins.

Seasonal Tailwinds.
Thinking shorter term, we are faced with multiple seasonal tailwinds at the end of the year. Traders who adhere to buy according to calendar cycles are coming back into the market, company share buybacks peak in Nov and Dec, and the ‘Do-Nothing’ congress is typically bullish for stocks as the gridlock in Washington, DC ensures that nothing that could affect businesses drastically gets passed (Fig 5).

Fig 5: US Mid-Term Elections Is Bullish For Stocks.

Chinese Growth Stabilising.
We have noted in the past that China, whilst slowing, did not appear to be headed for the hard landing which many observers feared. Chinese growth has stabilised in the past year, in the midst of their economic restructuring and anti-graft campaign (Fig 6). The sharp fall in energy prices will benefit the consumer in many emerging economies due to their energy dependence and the large component it makes up in the CPI. Whilst we have to accept that the new normal for Chinese growth could end up in the 6.5-7% range, when we contrast this with the rest of the world, China and the majority of the Asia Pacific countries appear in good stead (Fig 7).

Fig 6: Chinese PMI Shows Stabilisation.

Fig 7: Chinese PMI Shows Stabilisation.

Conclusion.
The world appears to be headed to a positive but slow growth environment. On a relative basis, some countries like the US, China and the Asia-Pacific region appear more positive from a fundamental and economic basis. The end of QE in the US is not a game-changer as lending conditions are on a much better footing. In addition, the ECB and BOJ are embarking on their own versions of easing, which will continue to supply financial markets with liquidity. Seasonal factors could drive equity markets to a nice finish in 2014 and we want to stay invested until data points change.



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