Finlight Research - Market Perspectives - Aug 2014

Market Perspectives

August 2014

Aug. 4th, 2014

www.finlightresearch.com

Nothing is happening, but something is going on.

“Never be afraid to sit a while and think.”Lorraine Hansberry

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FinLight Research | www.finlightresearch.com

Executive Summary: Global Asset Allocation

� The big economic picture is still benign and continues

to align with market bulls, but bullish conviction is

fading

� German and French data are globally disappointing. RecentUS housing data are soft and housing-related assets aresuffering

� The hope of the Fed (as other Central Banks) is that theycan keep the markets afloat through forward guidance asthey slowly reduce their liquidity support

� We think that yield hunting is the source of all fragility now

� Volatility in all markets is forming a base, and should

bounce from there

� Risky assets are not priced for any alternative scenario thanthe optimistic one. We do not want to be exposed to such

a biased situation..

� We continue to see the main systemic risk coming from

China. We keep a close eye on US inflation and oil prices

� We summarize our views as follows �

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MACRO VIEW

� The Good

� US real disposable income has increased at a solid rate: 3.5% in Q1 and 3.8% in Q2, pointing to strengthening consumer expenditure in the second half of the year.

� Business investment also increased by a solid 5.5%. � Conference Board consumer confidence was strong. � Any way you look at it, the 2014 Q2 earnings season has been very positive

� The Bad

� The strongest economy in Eurozone is weakening.� Equity sector action seems to be showing a late-cycle, highly defensive behavior, with Energy and

Materials leading while Consumer Discretionary, Financials and Housing names are lagging… and the broad market largely ignoring all of that.

� Pending home sales were weak.� Long duration Treasuries yields hit a new YTD low, probably implying more difficult times ahead.� Investor sentiment is broadly (too) optimistic : Investors Intelligence Bulls-Bears spread is near its

highest level

� The Ugly

� China’s economy continues to be supported with credit and stimulus, strengthening the problem of excess capacity and deflating the PPI. Without this support, Chinese economy will sink.

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Big Four Economic Indicators

� There is no indication of a recession using the indicators monitored by the NBER, even during Q1-2014� The average of these 4 indicators seems to suggest that the economy is moving sideways. This average

is hardly compatible with the sharp rebound we’ve seen in Q2 GDP!� We expect next revisions of Q2 GDP to be done to the downside

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ISM Manufacturing

� ISM Manufacturing hit its highest level since April 2011.� Of the ten components to the report, six increased relative to June, according to Bespoke. Biggest

contributors are Employment and New Orders.

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ISM Manufacturing

� The Eurozone economy is underperforming. Eurozone manufacturing is now clearly fading.

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Eurozone Lending

� Despite the extremely easy monetary policy, bank loans in the Eurozone continue to fall.� Tougher lending standards are probably due to new regulatory constraints on banks (stress tests…)

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Unemployment

� According to July’s Conference Board Survey, the Consumer Confidence Index jumped in July to 90.9, the highest reading since October 2007, benefiting from improvement in labor market conditions

� Consumers said that jobs are less hard to get, confirming the downtrend in jobless claims and jobless rate

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Unemployment – Alternate Measures

� The global picture is still puzzling,

especially for labor force participation

rate

� Compared to the official unemployment rate, U-6 is much higher at 12.2%.

� “Over the course of the last year, the working-age population rose by more than the number of people employed. In normal times, the unemployment rate would have gone up slightly. Instead, the unemployment rate fell from 7.3% to 6.2%. Over 100% of the decline in unemployment was due to people dropping out of the labor force, rather than strength in the economy! […] Were it not for people dropping out of the labor force over the past several years, the unemployment rate would be well over 9%.“ - Mike Shedlock

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GS – Global Leading Indicator (GLI)

� Little improvement since lastmonth. The July GLI came in at3.1%yoy, flat from last month.Momentum increased to0.25%mom from last month’sreading of 0.15%mom.

� GLI places now the globalindustrial cycle clearly in the‘Expansion’ phase (defined bypositive and increasingmomentum). But for how long?

� 6 of the 10 underlying componentsimproved in July

� We think that the current

acceleration remains quite

modest for a typical expansion

phase.

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Employment Cost

� According to the Bureau of Labor Statistics, the employment cost index rose 0.7% in Q2-2014, the fastest growth since 2008. � Wages and salaries increased

0.6% (the highest over 6 years). � Benefit costs increased 1% (the

highest over 3 years). � On a YoY basis, employment

costs are increasing at 2%

� Higher wages could push inflation higher, pushing the Fed to change its monetary policy.

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Eurozone Inflation

� The deflation theme is not dead yet in Euro area…

� Eurozone Inflation forecast has been continuously downgraded since Jan. 2013.

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Housing

� At 980,000 units-SAAR during Q2, housing starts are below their Q4-2013 level.

� Single-family starts have remained around 600,000 SAAR over the last months

� The long-term picture for housing is still concerning with low (and decreasing) housing starts and weak (and sharply decreasing) construction spending on home improvements

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Housing

� Weakness in housing has persisted, with homebuilders down over 7% YTD, hitting new relative lows in spite of declining yields

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Consumer Sentiment

� The University of Michigan Consumer Sentiment for July came in at 81.8, down from June’s 82.5 . This is the lowest reading since March.

� Consumer Sentiment has been range bound since 2012

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Chinese Economy

� China’s real GDP rose 7.5% YoY during Q2, after 7.4% during Q1

� On a seasonally adjusted annualized rate (SAAR) basis, real GDP rose 7.9%during Q2, up from 5.7% in Q1

� Chinese imports are telling another story: total imports over the last 12 months (in US dollars) are down 0.7% in June from its top in February.

� On a YoY basis, imports appear to flatten.

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Chinese Economy – A Credit-Driven Economy

� China’s economy continues to be

supported with credit and stimulus

� Recovery in PMI data is attributed to policy stimulus measures (infrastructure expenditure, corporate tax cuts and credit availability).

� Chinese bank loans totaled a record high of $12.6 trillion

� Easy access to credit is strengthening the problem of excess capacity, driving the PPI down.

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EQUITY

� We stick with our view that risk-reward trade-off points to a more cautious approach to the

equity markets, at least tactically on the near term.

� Since our previous monthly report, we’ve been waiting for a correction. It is probably materializing… S&P 500 suffers largest weekly loss in 2 years .The return potential for equity markets looks corrupted by limited room for valuation and margin expansion.

� We continue to think that any further upside on the S&P 500 should be driven by earnings

growth rather than P/E expansion

� On the S&P500, breaking the Nov. ‘12 uptrend around 1920 would be the first real sign of momentum loss

� The way Small Caps perform in the coming weeks may prove telling in terms of what to expect from Large Caps. If history is any guide, if Small Caps decisively fail, Large Caps may not be very far behind.

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EQUITY

� Bottom line :

� On DM equities, we are at the beginning of a typical technical correction with modest

fundamental support. A fast rebound should follow (for the moment) unless we break medium-term supports for the uptrend.

� We remain Neutral equities. Breaking through the 1900-1920 pivot area on the S&P500 would likely be the signal we wait for to go short stocks, as that could lead to a temporary sell-off in equities. We keep our UW on Europe vs. US.

� Although EM and Japanese stocks outperformed since our last publication, we remain neutral to UW on Japan and UW on EM. We keep our view on EM despite the fact that both currency and equity valuation measures look rather neutral. We are Bear on China despite the recent rebound in stocks

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Earnings

� Earnings are still growing. All measures of corporate profits are going up.� As shown below, S&P 500 earnings growth evolves between 5% and 7% per year. They are currently at

the top of their historical fluctuation range.� Forward earnings are also optimistic. They tend to track the 7% trend line.

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Earnings

� Earnings revisions have now stabilized in all regions except Europe.

� Downward revisions in Europe still dominate upgrades

Upgrades less downgrades, as percentage

of changes in estimates (last four weeks)

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Earnings

� According to FactSet report (Aug. 1st), of the 376 companies that have reported earnings to date for Q2 2014, 74% have reported earnings

above the mean estimate

and 65% have reported sales

above the mean estimate.

� The earnings growth rate for Q2 2014 stands at 7.5%, when the estimated earnings growth rate was 4.9%, on June 30.

� For Q3 2014, there are more negative EPS guidance positive ones. To be closely watched …

� The current 12-month forward P/E ratio is 15.1. This P/E ratio is based on July 31st closing price (1930.67) and forward 12-month EPS estimate ($127.97).

Source: FactSet

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US Equity – Large Caps

� The S&P500 uptrend has lost some of its momentum, as attempts to push above 1985 have been unsustained.

� A probable target for the current correction stands around 1900.

� Breaking the Nov. ‘12 uptrend around 1920 will give the negative signal we’ve been waiting for to go short the S&P500, as that could lead to a temporary sell-off in equities

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US Equity - Small Caps

� Just as we saw in 2000 and 2007,

Small Caps are no longer

sharing the same ebullience as

Large Caps

� Small Caps are giving signs ofweakness when large caps areclose to their all-time highs.

� The Russell 2000 looks like it’sforming a double top at the highsfrom Jul. and Mar. ‘14 (1213). Ithas already decisively broken theinitial uptrend from Nov. ’12, aswell as its 200-day movingaverage

� Next target ~1085-1093. Breakingthrough will confirm the double topstructure and imply that a fargreater declines may follow

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US Equity – Defensive behavior?

� Equity sector action seems to be showing a late-cycle, highly defensive behavior:

� with Energy and Materials leading while Consumer Discretionary, Financials, and Homebuilders are lagging (like in July 2007)

� when the broad market is hitting new multi-year highs with no volatility

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Chinese Stocks

� Technically speaking, the Shanghai Composite structure looks very bullish.

� The break through the triangle consolidation pattern sets 2270 (also Sep ‘13 high) as a possible target.

� We still think that despite this move, the index remains in a declining mood as long as the Aug. ‘09 downtrend (~2350) is preserved.

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US Equity – Valuation

� The composite indicator in red (due to D. Want from Prerequisite Capital Management) divides the CAPE by Moody's Baa yield, is reaching an extreme level, probably signaling that a major price top is near.

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FIXED INCOME & CREDIT

� Rate hike expectations for the Fed has been brought forward slightly, from Q4-2015 to H1-2015, as US growth has been steady over the last month

� We stay underweight on government bonds. We keep our short positioning on UST and expect 10-year yields to reach 2.90%-3.20% over next months, because of sustained US growth, increasing US inflation and decreasing inflation concerns in Europe. A sell-off in Govies may induce a sell-off in equities.

� We continue to OW Eurozone vs. US and UK given continued policy divergence and BCE action.

� An improving Eurozone growth outlook and ECB credit easing measures should induce further Peripheral-Core spread convergence. We see, however, reasons to be cautious as the current low volatility environment is encouraging complacency , especially with the periphery. In our view, the ‘peripheral theme’ has reached the end of line. We remain neutral Peripheral vs Core as we see

lasting spread compression to be very limited.

� Our view on TIPS breakevens is unchanged. Given solid retail demand, we remain bullish on

them and keep our 5y-TIPS breakeven wideners

� As a tail hedge, we keep our 10y bund swap spread receiver swap


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� In corporate credit, investors appear to be seeking out risk on the margin, moving down in

quality in search for yield, encouraged by low default rates and benign event risk

� We think that the search for yield is the source of all fragility now� US inflation surprising to the upside and accelerating the removal of monetary accommodation is the

worst scenario for credit, as it would provoke a risk-off bias for rates and equities

� We remain UW on corporate credit, due to valuation, to position within the credit cycle, to the expected rise in government bond yields and given the weak total return forecast

� Spreads are now so tight that carry and additional spread compression is not enough to compensate for the rise we expect in government yields (especially in the US). Despite this risk (which normally has a bigger relative impact on IG then on HY), we continue to prefer IG over HY on a risk-adjusted basis

� Intra credit, we keep our Neutral stance between the US and Europe. European credit has the potential to outperform its US counterparty. But the tail risk of systemic shocks in European financials is too big to be ignored.

� Bottom line : Still UW Govies, UW credit, OW TIPS, UW High Yield vs High Grade


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� This has been a minor move higher in spreads thus far, but as credit typically leads, one that

should not be ignored.

� We also like emerging market high yield corporates because they have relatively strong balance sheets and low expected default rates. Inflows into emerging market bond funds have also been positive, therefore generating positive price momentum for this asset class.


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US Treasuries

� An interesting relationship exists between Citi US Economic Surprise Index (ESI) and 3-month change in 10y UST.

� At this stage, and unless the data disappoint, we expect ESI to rise into positive territory driving UST yields 50bps higher

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US Treasuries – Defensive behavior?

� US 30 year bond yields hit a new YTD low (as did the curve slope), probably implying more difficult times ahead.

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US Curve Flattening

� There are many spread charts which suggest a significant flattening of the U.S. curve over the short term.

� The flattening is driven by higher short-term rates.

� According to CFTC data, speculator positioning in USD Libor futures is the most short it has ever been

� The market is apparently thinking the

Fed is behind the curve…

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US TIPS

� Core inflation is not accelerating yet, but inflation pressures are increasing because of the declining unemployment and rental vacancy rates

� Fed communication has continued to tilt in a more hawkish direction. Talking about inflation in its last FOMC statement, the Fed replaced “has been running below the Committee’s longer-run objective” by “has moved somewhat closer to its target”.

� Morningstar’s 12-week sum of weekly flows into inflation-related mutual funds is at its highest level since end 2012

� We remain bullish on TIPS breakevens

and keep our 5y-TIPS breakeven

wideners

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Credit – High Yield

� Signs of weakness are showing in High

Yield markets.

� US HY spreads have been widening since late June.

� A similar behavior is seen in European credit despite the recent move to negative interest-rate policy

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� Another sign of weakness in HY: the spread between IG and HY is bottoming…

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� Debt increased from Q1-2013’s 7.4xto Q1-2014’s 8.6x core profits of nonfinancial corporates� Rising ratio of debt to profits usually points to wider HY spreads

� So far, HY spreads have delivered a contradictory response to the rising ratio., increasing the risk of a sharp sell-off in HY credit.

Source: Moody’s, Financial Accounts of the US

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� Outflows for high-yield bond funds are the largest since June 2013

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EXCHANGE RATES

� We continue to expect the USD to strengthen against the major crosses.

� The ECB’s dovish rhetoric and action should gradually drive the Euro weaker. US GDP surge to 4% in Q2 gave another sign that the US and Eurozone economy are diverging. The EUR-USD underlying structure looks very negative.

� On EUR-USD, we remain UW and target 1.31 - 1.28.and ultimately 1.25

� The ongoing deterioration in Japan's current account deficit , further policy initiatives (including both additional QE and asset allocation out of domestic bonds), combined with the rise in US yields, should drive USDJPY higher

� On the USD-JPY, after a consolidation phase during which we moved from UW to Neutral (please see our previous report), the rally of the USD appears to be resuming with a break higher through a triangle consolidation pattern. Thus, we switch from Neutral to OW and target 105.45

� EM fundamentals still feel less robust broadly speaking: As the Fed continues to taper (without being hawkish), we expect many EM currencies to remain under pressure versus USD :� Over the short-term, carry trades USD-EM should continue with stable USD and low volatility� Over a longer term (more than 6 months), we get closer to effective Fed tightening and would see

USD gains versus EM currencies and a higher volatility


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EUR-USD

� EUR-USD is back on the 1.34 level suggesting an end to the USD weakening trend

� The EUR monthly chart is our favorite. It is

particularly bearish.

� The chart shows that a clear topping structure is already in place

� The downtrend from Jul. ‘08 high was preserved


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USD-JPY

� The USD-JPY remains above the 100 key level. That suggests a continuation in the yen’s long-term weakening.

� Recent production data reinforce the idea that Abenomics economic impact is weakening.

� USD-JPY seems to be breaking higher through a triangle consolidation pattern.

� A reasonable short-term target should be January high at 105.45.


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VOLATILITY

� Volatility has declined across all asset classes with implied and realized volatility in bonds, FX and equities at or near all time lows.

� The market’s anticipation of the first interest rate hike by the Fed (probably during the H1-2015) starts to be a source of volatility as the market hesitates between tightening effects and growth

� Our view is that volatility is bottoming after months of historical lows through improving

economic outlooks. After the technical reversal we saw in the last days of July, we should start to see upward pressure on it over the coming months, with rising inflation volatility, rising earnings volatility and increasing default rates and macro surprises

� Exhibiting volatility positive positioning, Emerging Markets, Macro Multi-Strategy and Macro

Currency hedge funds are likely to deliver important, uncorrelated returns

.

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Volatility across Asset Classes

� Volatility has declined across all asset classes with implied and realized volatility in bonds (MOVE) , FX (CVIX) and equities (VIX), Crude and Gold at or near all time lows.


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USD Volatility

� USD-G10 1-year implied volatility is probably setting a base and ready to bounce

� It is worth to see that the base is very close to the prior cycle low in 2007

� The expected rebound has to be confirmed by a clean break above the downtrend from Sep. ‘11 - less than 1Pt above the current levels.


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Gold Volatility

� On Gold, volatility is also on historical lows. A bottom seems to be forming.

� The smile is symmetric as an indication of the uncertainty surrounding the next trend direction,


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COMMODITY

� We continue to think that commodities hold value as cross-asset portfolio diversifiers.

� While we are neutral on prices we continue to see substantially positive roll returns in many

commodities.

� Commodities were the best performing asset class in H1-2014. Over that period, all 5 commodity sectors have contributed positively to overall index returns. The picture has changed in July with a higher

level of dispersion across commodity markets. But volatility within all sectors continues to trend lower despite high geopolitical risk.

� The S&P GSCI index is almost back to the same place it started the year. But that should not hide the high level of dispersion across commodities, neither the value of carry locked in some sectors with backwardation (the enhanced S&P GSCI is up 2.1% YTD when the spot is flat)

� We’ve been UW since end of Feb. ’14 and till end of Jun. ‘14. Over this period, commodities have been rangy.

� In our July report, we upgraded our commodity allocation to OW on energy (on geopolitical tensions) and base metals (especially Zink, Nickel and Aluminium), favoring commodity futures with steep

backwardation (for positive carry). We also remained UW on agriculture (except on premium coffee and cocoa) and precious metals.


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COMMODITY

� Based on July returns, our bets have proven right except on energy.

� We change nothing to our previous views. We choose to keep our OW bias on energy (especially crude oil) because of attractive carry, geopolitical risk in Ukraine and Middle-East and the view that Libyan production estimates are far too optimistic.

� Within base metals, we still prefer Aluminium, Zinc and Nickel as these metals suffer from a low supply growth following years of underinvestment

� Over the second half of 2014, we continue to see significant downside for :� Agriculture, as there are expectations of record inventory builds for staple cereals. We keep

however our OW view on premium coffee and cocoa because of the risk of El Nino and weather volatility around the equator

� Precious metals: We think that recent gains in gold cannot be sustained as US real rates, the S&P500 and the US dollar move higher. We expect precious metals to resume their downward trend (targeting 1180-1150 on gold and 17 and eventually 12.50 on silver)

� Among base metals, Copper is expected to underperform sharply over a 3-12m horizon, due to sluggish demand growth, especially by the construction sector in China. We target 6400 (Q3-2014), and ultimately 6000.


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Gold

� Gold price rebounded above US$1,300 on safe haven search driven by growing geopolitical concerns

� We continue to believe that strength

in gold price is unlikely to last and

that the next major move in the price

of gold will be lower. A probable trigger for that will be a more clearly hawkishUS monetary policy

� In gold, net longs are reaching a local top and would probably decrease over the short term.


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Gold

� We keep our bearish view on gold.

� We expect gold to resume its preceding downtrend.

� We are currently on an important pivot area around 1285-1290. Breaking this support should drive the gold to the next big support around 1240.

� We still target 1180 - 1150


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Miners

� Mining sector valuations are now at attractive levels, as earnings downgrades have stalled, EPS seem to have reached a bottom and GSCI Industrial Index starts its recovery…


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ALTERNATIVE STRATEGIES

� July was a challenging moth for hedge funds as equity and credit markets pulled back from record highs into month end, Argentina defaulted and commodities recorded sharp losses

� It is worthwhile noting that:� Hedge funds seem to be reducing their longs in stocks � Long-Short Credit funds started to decrease their long positions in credit since June� In Global Macro funds, short EUR-USD positions are finally paying off� Macro Multi-Strategy hedge funds posted gains from positions in currency and fixed-income, from

short exposure to equities, high yield credit and commodities

� While preferring risk diversifiers to return enhancers, on a risk-adjusted basis, we keep our OW on:� Equity Market Neutrals despite its disappointing performance over the last few months� CTA’s and Global Macro as a diversifier and tail hedge. We proved correct with the Middle-East

geopolitical risks � Vol. Arb strategy and prefer funds that trade volatility globally (all assets / all regions). This strategy

has shown a great ability in terms of protecting capital during adverse periods, and a volatility that compares favorably with the hedge fund industry.

� Exhibiting volatility positive positioning, Emerging Markets, Macro Multi-Strategy and Macro Currency

hedge funds are likely to deliver important, uncorrelated returns. We move OW on these strategies.

� We move from OW to Neutral on Event-Driven, as M&A activity is calming down, volatility is likely to bounce, and geopolitics are taking the lead


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Hedge Fund Positioning - Equity

� In our previous report, we emphasized the fact that hedge funds had become quite long in stocks. � They seem to be reducing their longs.


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Hedge Fund Positioning - Credit

� Long-Short Credit funds started to decrease their long positions in credit since June. Their net credit exposure (seen through the Lyxor platform) was reduced from 70% to 40% of NAV between mid-June and mid-July.


Bottom Line: Global Asset Allocation

� The big economic picture is still benign and continues

to align with market bulls, but bullish conviction is

fading

� German and French data are globally disappointing. RecentUS housing data are soft and housing-related assets aresuffering

� The hope of the Fed (as other Central Banks) is that theycan keep the markets afloat through forward guidance asthey slowly reduce their liquidity support

� We think that yield hunting is the source of all fragility now

� Volatility in all markets is forming a base, and should

bounce from there

� Risky assets are not priced for any alternative scenario thanthe optimistic one. We do not want to be exposed to such

a biased situation..

� We continue to see the main systemic risk coming from

China. We keep a close eye on US inflation and oil prices

� We summarize our views as follows �

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Disclaimer


This writing is for informational purposes only and does not constitute an

offer to sell, a solicitation to buy, or a recommendation regarding any

securities transaction, or as an offer to provide advisory or other services

by FinLight Research in any jurisdiction in which such offer, solicitation,

purchase or sale would be unlawful under the securities laws of such

jurisdiction. The information contained in this writing should not be

construed as financial or investment advice on any subject matter.

FinLight Research expressly disclaims all liability in respect to actions

taken based on any or all of the information on this writing.

About Us…

� FinLight Research is a research-centric company focused on Asset Allocation from a top-down

perspective, on Portfolio Construction, and all related quantitative aspects and risk management issues.

� Our expertise expands along 3 axes:

� Asset Allocation with risk control and/or risk budgeting techniques

� Allocation to alternative investments : Hedge funds, rule-based strategies (momentum, value, carry, volatility), real assets (real estate, infrastructure, farmland, timberland and natural resources). Private equity and venture capital should be the next step…

� Allocation with a factorial approach built on the understanding (profiling) of the risk/return drivers of the different asset classes

� FinLight Research is an innovation-oriented company. We target to fill the gap between the academic research and the investment community, especially on real assets and alternatives. We survey on a continuous basis the academic literature for interesting published and working papers related to quantitative investing, non-linear profiling, asset allocation, real assets...

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Finlight Research - Market Perspectives - Aug 2014

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Transcript of Finlight Research - Market Perspectives - Aug 2014