31 December 2015

Upside Down

Executive Summary

The Oil and commodity sector has recently made headlines again as the financial media tries to make sense of what is happening in the markets. Looking at the data, we do not see contagion from the fallout in the oil and commodity sector spilling over to other sectors of the market. However, given that energy forms nearly 20% of the high yield bond market and 10% of the S&P 500 index, it is no surprise that the collapse of earnings in this sector makes the overall market appear weak. As such, we would like to highlight that in such a market scenario, selectivity is key. Being completely underweight to energy and commodities and choosing managers to bottom-fish will bear fruit. 2015 has turned out to be quite an insipid year. For 2016, we are going against the general market consensus as we view 2016 as a much more positive year despite it being an election year for the US. We will rely on our risk matrix to tell us when to get out of the market when a major bear market is imminent; thus for the time being, it’s all systems go.


A Look Back At 2015.

We have continually repeated that we are not in the business of forecasting. However, when we take in the weight of our data, we are able to discuss and put forth some interesting ideas for our clients. Here are our top three articles of 2015 which we find have even more relevance now in today’s markets.

  1. Bonds – Why You Need To Be Worried (Apr 2015)
    We highlighted the risks in the fixed income market, especially in the High Yield and EM space. We felt that fixed income would be facing secular headwinds given a rising interest rate environment, reduced liquidity and the amount of AUM that investors had poured into the asset class since 2008.
  2. Worried? Only If You’re Gambling! (Jul 2015)
    In this article, we discussed how the Chinese stock market collapse was not the end of the world and the intricacies of the local market and effects of Chinese restructuring.
  3. K.I.S.S. (Sep 2015)
    Here, in the midst of the confusion after the Aug equity sell-off we stressed the need to remain clear-headed, simplify and to assess all available data instead of being swayed by emotions. Our risk matrix had signalled us to reduce risky positions, but with overall evidence showing that a large bear market was not imminent, we were confident that the sell-off would be quite short lived and that further weakness would present a buying opportunity.

Some of our key calls made for 2015:

Main ViewsOutcomeSuccess
No global recession but at a growth rate much slower than previous recoveries. Prefer equities over bonds as the Risk Premium remains attractive. Global growth was downgraded several times throughout the year mainly driven by the slowdown in the larger emerging economies. However the equity call did not pan out as planned as markets have ended the year lower than when they started.
US Economic expansion to continue, helping the US equity market achieve a mid to high single digit return. Remain overweight on the US. The US economy continued to recover but the equity market looks set to end 2015 in negative territory.
Gradual recovery in the Eurozone will be helped by the weak Euro and led by export-oriented economies like Germany. Greece to be a potential high-risk event but the impact on markets to be small. Remain overweight on Europe. Europe has benefited from the ECB’s QE program with loan growth in many economies recovering. The European market appears likely to end 2015 with a small gain.
Mixed outlook for Asia-Pacific with our preference towards service-oriented Emerging Asian economies that will benefit from cheaper commodity prices. We have not seen the effect of cheaper commodity prices on Asian consumer sentiment yet, but our underweight allocation to Asian markets has helped.
The end of the commodity bull-run and the end of EM-led growth. Remain underweight EM markets and their currencies. EM continues its downward spiral this year with commodities falling even further.
The US Dollar to continue its uptrend versus all of its partner currencies, mainly led by the potential Fed rate hike, and the stronger economy. The stronger US dollar has helped with our investment positions as majority positions are denominated in US dollars. Although markets are negative Year-to-Date, the strengthening currency has helped mitigate the losses.
2015 to usher in an era of more volatile equity, fixed income and currency markets. Markets were quite calm for the first half of the year, but then the August sell-off triggered big bouts of volatility. Our risk matrix also signalled to reduce our risk positions which we did.
The bond market to be a potential minefield after the phenomenal rise in issuance thanks to central bank monetary stimulus and reduced liquidity after the removal of bond trading intermediaries due to Dodd-Frank. We were early calling for the decline in bonds as the Fed kept pushing its rate rise further back in the calendar but we have now seen a big decline

Bond Market Stress

Financial observers have been quick to point out the bad omen due to the recent spike in bond yields from high yield fixed income. We agree that widening credit spreads and increasing yields are negative for stocks in general and serves as an initial warning sign for equity investors, but would like to highlight that it had been coming from a very low base. One cannot compare this with 2007 when bond spreads spiked up dramatically due to the imploding US mortgage market. However, rising rates provide headwinds for the equity market so we will be carefully watching our indicators for signs of stress. So far, nothing significant has shown up apart from some technical weakness.

In a rising rate environment, we would want to watch interest expenses of companies, because the cost of borrowing can overwhelm a company’s ability to generate profits. This is typically a precursor to a recession. Currently, the interest expense of S&P500 companies are at an 18-year low, however we see that this will begin to rise in line with rising yields (Fig 1). While not a matter of immediate concern, we need to keep this in view especially in the next 12-24 months.

Fig 1: S&P500 Payment of Debt at a 18-Yr Low But Expected To Rise In Line With Rising Rates.

Digging deeper into the high yield bond market, we see that the stress is likely due to concerns over the weak commodity sector (Fig 2). Energy, metals/minerals and utilities’ bond issues make up 25% of the US high yield market, with utilities and materials being the most levered companies at nearly 6X earnings to interest expense coverage (the higher then worse). However, the area showing the most stress is undoubtedly from the US energy sector – especially from Shale E&P (exploration and production) companies which took advantage of cheap borrowing to finance their activities. With oil expected to stay lower for longer, it is likely that many of these companies will come under pressure to repay their borrowings.

Fig 2: US High Yield Energy Bond Yields Have Increased Dramatically Since the Collapse in Oil Prices

A final closing point on high yield concerns is that it appears to be localised to the US market only, and specifically to the energy sector. When you compare the overall US High yield market to the Asian high yield market, you will see that the fear did not spread to the Asian region (Fig 3). If there had been inherent systemic stress, all markets would have been affected.

Fig 3: US High Yield Sell-Off Did Not Extend to Asian Markets.

Oil, Again!

Exactly one year ago, we also had oil fears. Then, commentators hinted that weak oil equated to weak demand which meant a possible global recession. There were concerns of a Russian default and possible collapse from other oil producing emerging countries. This time round, weak oil is creating fears of possible contagion from the fallout of energy related firms defaulting on their loan obligations. We do not see immediate problems from this given that banks are well capitalised based on the Basel III accord and this is unlike the mortgage crisis in 2007. In addition, the chart below shows that recessions are typically not caused by a drop in oil prices, but rather a spike up in oil prices which suddenly makes things very expensive for both companies and consumers (Fig 4).

Fig 4: Oil Price Spikes Usually Cause Recessions and Not The Other Way Round.

Less Joy For Santa

This year’s market action has not provided investors with much cheer. In fact, with volumes dropping off because of the holiday season, the fear exhibited by investors has contributed to the negative returns month-to-date. We are cheered that the lack of euphoria means that the market can push higher in the new year (Fig 5) on the back of this contrarian view and seasonality factors (Fig 6).

Fig 5: Pessimistic Investors Is a Contrarian Bullish Sign

Fig 6: The Market Is Usually Buoyed By Positive Seasonality During This Period

Current State of Affairs and Peek Into 2016

Our risk matrix is currently at amber. As such, we view the current market as neutral with moderate risks. Breaking it down, we see that the technical damage caused by the Aug sell-off has still not recovered to previous levels. However, as fundamental data remains positive and there had been no further deterioration to our technical signals, we recently upgraded all portfolios back to normal allocations. However, we remain on watch to quickly cut risky positions if our risk matrix turns red.

A quick look at the different asset classes across regions for 2015 shows uninspiring performance and the last time this occurred was in 1937. Typically, in a given year, a certain region or asset will end the year with double-digit gain. Of all equity markets, only China-A Shares and Japan look set to end the year with a 6-7% gain. Everything else should end 2015 flat or negative, with the worst 3 areas being oil, Singapore equities and Emerging Market equities (Fig 7). As asset allocators, these type of markets hurts us but we make no excuses and we will continually improve and strive for better performance in the years ahead.

AssetPerf YTDAssetPerf YTD
Commodities(All)-14.9%WTI Crude-29.6%
S&P 500 Equity0.0%Gold-8.9%
Japan Equity6.0%Global Equity-3.4%
Singapore Equity-19.4%EM Equity-15.8%
Europe Equity-3.2%USD Aggregate Bond-2.8%
China(H) Equity-8.6%G7 Bond-1.7%
China(A) Equity7.0%Investment Grade Bond-4.3%

Fig 7: Performance of Different Asset Classes in 2015

What makes us so positive for 2016 and different from what the other commentators are saying? For one, we do not see the US Fed rate hike affecting markets. Measuring liquidity in the markets, it actually shows that we have reached levels similar to 2012. Such excess liquidity would usually find its way into the equity market (Fig 8). When you couple this to investor pessimism, it still makes a compelling case for equities.

Fig 8: Spread Between M2 Growth and IP Growth Has Increased and The Excess Liquidity Usually Will Enter the Equity Market

The other overhanging worry is the valuation of the market that many strategists highlight as being the stumbling block for markets in 2016. When we look at the long term metrics, the market looks stretched only from a cash-flow yield perspective. The correction in Aug/Sep helped bounce the market off its mean, but if you are talking about overstretched, bubble like conditions, then we are far from it (Fig 9).

Fig 9: Global Valuations Whilst Not That Cheap Are Not at a Euphoric Stage by Any Means.


We end the year feeling upbeat amidst the sea of (mainly) despair as we see much more positives with big risks receding. We will continue to be guided by our risk matrix to avoid major bear markers. As such, we have reasons to look forward to a Happy New Year!

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