24 June 2015

Macro Strategy Update

Unloved

Executive Summary: We continue to remain in a slow growth environment. Markets have largely been trendless with investors unsure of what to do. We will remain invested, with our risk-on allocations guided by our Risk Matrix and continue to be positive on the broad US, Europe and Emerging Asia regions. US rate hikes are on the horizon but it merely means that the world’s largest economy is coming back on track. This does not derail the most unloved bull market in history but can be punishing for bond holders. It is recommended that we shut out all the noise and focus on the fundamentals instead.

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With nearly half the year gone and another half year more to go, it is time to take stock of what has happened and position ourselves appropriately for what is to come. The choppy action both in the stock and bond markets show that investors are unsure of what to do. With the US and China at multi-year highs, many are unsure whether the market rally can continue. Bombarded by the media harping on the impending collapse of Greece, Shanghai’s leveraged stock market, the prospect of rising interest rates and the sudden sell-off in bonds, it may seem that it would be better to run towards safe havens. However, staying invested proved to be the best choice as markets continued to grind upwards despite the lack of a clear trend. We could be in the midst of the most unloved bull market in history and as long as our Risk Matrix gives us the green light, we will continue to stay fully invested.

Global Economics
We have highlighted in our earlier articles that the world would continue to grow, albeit at a slower pace and this has proved to be true (Fig 1). However, there are implications to this proposition as it means that we have to accept the fact that we will occasionally face bouts of weakness to growth, corporate earnings will not be as spectacular as in past recoveries, US rate hikes will be more sedate, and export-oriented countries would have to shift away relying on China to drive their economies.

Fig 1: Growth is There, But at a Slow Pace

Global Trends
We continue to hold on to our longstanding themes and trends. For equity markets we continue to favour the US, with a smaller overweight to Europe and Emerging Asia. We have turned positive on Japan on the back of continued strong momentum, improved economic prospects, increased share buyback activity and better corporate governance. We will seek to initiate an overweight at an appropriate time. For bonds, we continue to remain circumspect, preferring short maturity issues and flexible mandates to guard against the rate rise. Whilst global equity market breadth has trended largely at neutral levels, there has been an increasing participation in the long term uptrend (Fig 2).

Fig 2: There Could Be Some Consolidation Ahead as Only 54% of Markets are Above 200DMA but Long Term Uptrends Remain Intact

Fear Factor
Professional investors have not been spared by the uncertainty in the markets. One of the factors of the largely trendless market has been that sentiment has been stuck at neutral levels since the start of the year (Fig 3). Investors have not been bearish enough for the market to sustain another leg up and neither have they been optimistic enough for the market to enter a meaningful correction. A recent fund manager survey also revealed that institutional investors have increasingly been hedging their portfolios likely because of where valuations are and fears related to Greece (Fig 4).

Fig 3: Investor Sentiment Shows That They Do Not Know What To Expect

Fig 4: Managers Are Facing a Wall of Worry

Greek Fatigue
Could there possibly be less news on Greece? Probably not and the media has been very happy to stress the words “crash”, “critical” and “crisis”. Any possible crisis from the Greek saga will be largely contained as the private sector has been ring-fenced since 2012 from a debt exchange program. The debt that Greece owes in the near term is primarily due to institutions like the ECB and IMF. The breakdown of the debt also shows that a large chunk of the debt is owed to European institutions through the European Financial Stability Facility and bilateral loans (Fig 5). As a result, we are less concerned by the Greek drama but (Fig. 6) briefly delves at three possible outcomes which could arise from this. Currently, it appears that a hybrid of Scenario A & B ends up the most likely path but the main takeaway from all scenarios is that the Greek prime minister ends up losing in all cases.

Fig 5: Greece Has Two Large Debt Repayments Due Soon and the Majority Of the Debt is Owed to European Institutions With Little Private Sector Involvement

Fig 6: All Roads Lead to Pain for the Greek Government

Fed Rate Rise
Following the recent Fed statement and Fed Chair’s press conference the consensus view appears to be Sep 2015 for the first rate hike with the possibility of two rate hikes this year (Fig 7). This comes on the back of weak US Q1 growth which was deemed “transitory” and the IMF urging the Fed to delay hikes. However, the Fed has highlighted that it would provide ample messaging and guidance in order not to shock markets and that rate hikes will be gradual and steady. This would not derail equities in general but will cause some short term readjustments to dividend yield plays. The likely losers will be longer duration investment grade bonds especially sovereigns and we have already started to see increased fixed income volatility and a sell-off since the beginning of May. Also solidifying the case for the rate hike is one of the most watched charts in the world (Fig 8) which estimates US GDP growth at 1.9% up from 0.6% less than a month ago.

Fig 7: Market Consensus Sees the Fed Starting To Hike in Sep 2015

Fig 8: Atlanta Fed’s Econometric Model Sees Better Q2 Growth

Conclusion
Investors have been buffeted by a variety of worrying news for the first half of the year and were likely taken aback by the choppiness especially in the fixed income and currency markets. Despite some diverging signals, we still expect the uptrend in equities to continue and remain confident in global growth. We are aware that risks remain elevated, but until our Risk Matrix signals otherwise, we prefer to stay invested and capture whatever opportunities the market may offer.



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