Finlight Research - Market Perspectives - Sep 2015

Market Perspectives

September 2015

Sep. 4th, 2015

www.finlightresearch.com

When China sneezes, the world just might catch a cold…

“Every single major global recession in the last

50 years has started in the United States. The

next global recession will be made in China.”

– Ruchir Sharma - Head of EM for Morgan

Stanley IM (July 2015)

“The crisis takes a much longer time coming

than you think, and then it happens much faster

than you would have though.”– R. Dornbusch

2FinLight Research | www.finlightresearch.com

Executive Summary: Global Asset Allocation

� As trumpeted for months now, Chinese economy was the eye of the

storm. Concerns about its growth and fears of global

recession/deflation triggered the panic on the global capital markets

� The deflation and growth scares morphed into a vicious cycle over the pastfew weeks.

� Our sentiment is that the risk-off tide is rising. The market sharp sell-offsuggests that something big is unfolding. The bull market is probably notbroken but seriously damaged.

� The long-awaited (10-15%) correction on stocks has finally occurred. But westill believe that equity markets are living on borrowed time

� The last time markets experienced the type of volatility that we are currentlywitnessing across all asset classes was in 2008. The volatility regime

switching we’ve been signaling for months is finally confirmed.

� Anticipation of rising interest rates will contribute to fear and volatility in thestock market. The last payrolls report keeps a September hike on the table

� We maintain our view that commodities will underperform, US$ will continueits rise, and volatility will remain high.

� A confluence of forces are converging to disrupt global equity and debtmarkets.

� We reiterate our view: A perfect storm is building… It combines historicallyovervalued stocks with stretched government bonds and corporate credits.Unlike previous storms (2000, 2008), investors would be left with almost

no place to hide

� We summarize our views as follows �


MACRO VIEW

� The Good� The second revision to US Q2 GDP growth came in surprisingly strong at 3.7% vs a previous

2.3%. � Consumer confidence is very strong according to the Conference Board survey.� US employment improved by most measures

� The Bad� At 0.2% (and 1% core) the Eurozone's inflation rate is far away from the 2% ECB target.� Japanese economy is contracting again (-0.4% in Q2-2015)� Chinese growth is slowing. China's manufacturing PMI came with its worst reading in three

years (49.7 vs. 50.0 in July). Turmoil in China's equity market has reached extreme levels.� August manufacturing PMI has disappointed everywhere, except in Germany� US productivity is anemic. Over the past 70 years, its growth has never been weaker except

in the 1976-82 period.

� The Ugly � Main systemic risk resides in China: The Chinese debt burden is extremely high and the

credit cycle is probably starting to turn. We are probably in the early stages of a bursting credit bubble.

� The fixed-income / credit edifice is highly vulnerable to China’s need to liquidate Treasury reserves in order to maintain its currency peg, as capital outflows increase and market widely expects further devaluation in the USD-CNY



The Big Four Economic Indicators

� The current picture is characterized by relatively strong Employment and Income, a weak Industrial Production and an erratic to weak Real Sales.

� The average of these indicators suggests that the economy is still trending sideways. But setting a new high still seems possible over the short term.


US Employment

� US employment has been fallingsteadily by most measures.

� Wage gains were 2.2% on a year-over-year basis.


US productivity

� The disappointingly-slow pace atwhich the US economy is growingmay be explained by the sharpdecline in productivity

� Over the past 5 years, productivityhas increased by 0.54% per year onaverage, a very weak growth ratesimilar to the one experienced duringthe 1976-82 period!

� The declining productivity is thenatural result of reduced investmentand a general aversion to risk-taking


GS – Global Leading Indicator (GLI)

� The Aug. Final GLI came in at1.3%yoy. Its MoM momentum isdown to 0.11%

� According to last estimates, GLIhas crossed the border from theExpansion phase to the Slowdownphase, since June

� Four of the ten underlyingcomponents of the GLI improved inAugust. Most manufacturingsubcomponents, including theglobal PMI declined over themonth.

� We continue to think that theacceleration we’ve beenwitnessing since Jan. ‘15 is quitemodest for a typical expansionphase


Chinese Economy

� Chinese growth has been slowingsince 2010

� Two (electricity consumptionand rail car volumes) of the 3indicators we usually use toassess the economic health inChina have declined during H1-2015 . Only bank lending continuesat the same pace.

� The official 7% GDP growth isclearly outdated. The economy hasbeen probably flat over the quarter!


EQUITY

� Is the long-awaited correction over? We think that a new test of recent lows is very likely…

� The S&P500 has been rangy for most of the year. At the top of the range, 2130 is probably the level that will make or break the market over the short-term.

� If the S&P500 was going to move higher (breaking the 2130 ceil), it probably would have done it by now. Given the weakness in the transports and Russell 2000 (and other market breadth weaknesses), we view the bias to the downside and think that the top is already in place (80% chance).

� At this stage, the bullish trend has been definitely damaged, as the S&P500 breaks its trendlineacross the lows since Oct. ‘11 at around 2000

� Recent data shows more evidence of lower productivity, lower potential GDP growth and (later) higher inflation risk. � This is a bad scenario for stocks

� We still believe that equity markets are living on borrowed time because…

� Earnings season hasn't provided the catalyst needed for the breakout to the upside� Valuations are well above historical norms, especially when we take into account the slower

revenue growth, the lower margins and the starting wage pressures � With the market already lofty, a 1.5% revenue increase (for Q2-2015 on S&P500 excluding energy)

doesn't give a lot of upside room.� The coming rate hikes will depress all asset prices for at least a part of next year� The market wild moves during August suggest that something big is indeed unfolding.


EQUITY

� Bottom line :

� For months now, we’ve been asking our clients to incrementally "de-risk" their portfolios by focusing on higher quality / more defensive / more favorably priced companies.

� We moved from Neutral to UW equities the S&P500 broke its trendline across the lows since Oct. ‘11 at around 2000

� We may revise our view to Neutral if the S&P500 breaks above 2000-2050, and to OW after a clean break of the 2070-2130 range.

� Other markets (FX, credit, commos, volatility) suggest stocks are still the odd man out. The risk/reward remains in favor of waiting, rather than being fully invested, until there is more clarity

� We stopped our (FX hedged) OW and moved to Neutral (vs US) on Japan as the behavior of the Nikkei around the important level of 21 000 was deceiving, and our toppish view on USD-JPY was confirmed. Japanese equities were the worst performing DM market driven by the proximity to EM Asia. Weak demand from China is expected to continue to weigh on Japan's production.

� We remain Neutral on Europe vs. US despite the policy divergence between the Fed and the ECB. According to the 12 month forward P/E, Europe is trading at 15 year highs, relative to the US

� We remain UW in US small caps vs large caps.


US Earnings

� For Q3 2015, 77 companies have issued negative EPS guidance and 30 companies have issued positive EPS guidance

� The 12-month forward P/E ratio for the S&P 500 now stands at 15.3, down from 16.5 last month, but still above historical averages: 5-year (14.0), 10-year (14.1)

� For Q2 2015, earnings growth stands at -0.7%. The last time the index reported a YoY decrease in earnings was Q3 2012 (-1.0%, the Fed came with its QE4 later that year).

� Of the 495 companies that have reported earnings to date for Q2 2015, 74% have reported earnings above the mean estimate and 51% have reported sales above the mean estimate. This is below the 5-year average (57%).

� Most of the deterioration in earnings momentum for the S&P 500 is due to the Energy sector

� If the Energy sector is excluded, the earnings growth rate would jump to +5.7%


US Equity – Insiders Buying

� The ratio of buyers to sellersamong corporate insiders isheading north, crossing the LTaverage of 0.5 for the first timesince 2012.

� We look for an inflection point inthis ratio before hoping a bottomformation in equities.


US Equity Volatility

� The connection between implied volatility and stock prices has been extremely strong over the last months. This is probably due to hedging activity (option writing) and systematic strategies (trend-followers, risk parity portfolios)


Equity Volatility / Correlation

� Implied S&P 500 volatility, skew and correlation are pointing to extreme market conditions.

� Implied S&P 500 volatility spiked to extremes. And so did the vol skew!� Implied S&P 500 stock correlations surged to its historical highs.


US Equity – Margin Debt

� We look at margin debt (as a % of GDP) as a warning flag.� At $464 billion in April, the margin debt is at its all-times highs, and represents 2.78% of the US GDP. � Similar extreme levels have never been reached except twice: in Mar. 2000 (2.78%) and in July 2007

(2.62%). � We seem on the verge of a “nervous breakdown”


S&P500 – A MT Perspective

� Weekly and monthly S&P 500 charts show a loss of momentum. New market lows are plausible..

� On monthly basis, the MACD breaks through the zero line

� In the past, this has been a very good indicator of very important market inflection points


S&P500 – A Medium-Term Perspective

� As said in our previous report, we interpreted the material break below 2000 (trendline across the lows since Oct. ’11) as a signal that the underlying trend is definitely damaged.

� We moved UW stocks on Aug 21st, and we will stay so as long as the trendline across the lows since Oct. ‘11 is not broken to the upside.

� We would start to get uncomfortable if the S&P500 goes above 2030-2050

� The next level to watch is the 2009 uptrend around 1700.


Equity Volatility – Regime Switching Confirmed

� On Oct 13th, 2014, our regime switching model pointed to a major shift in the S&P500 volatility regime

� Since then, the VIX index has left the “Low Vol” regime, and started to migrate between the “Medium Vol” and “High Vol” regimes

� The last time we’ve seen a similar behavior on the VIX was in July ‘07.

� The last turmoil provides an additional support to this hypothesis


Chinese Stocks

� The Shanghai Composite Index reversed sharply higher on its Aug 26 bottom.

� But despite the corrective rally underway (with a plausible target at 3700 - 4000, the downtrend is still preserved. We keep our negative bias on Chinese equity.


S&P500 – A Short-Term Perspective

� As of Sep 4th , our prop. Short-Term trading model is flat on the S&P500 (@1921.22).� Out of the 5 active systems, 3 are long with 1961 and 2041 as targets. The other 2 are short with a

target at 1903

� The model has been in drawdown since Aug 20th, as it was massively long when the sell-off occurred. It became almost flat at the close of Aug 26th (@1940.51) making up its losses partially.

� The model has boosted its return generation since Oct. ‘14, exhibiting a pattern similar to the one we’ve seen after Jun. ’07. Even the last drawdown is similar to that started on Jun 6, 2008

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FIXED INCOME & CREDIT

� We still believe the Fed is on track for a September rate hike (the stronger than expected US labor market report supports this view), when the market continues to price such a scenario very partially. UST yields remain underpriced relative to this scenario.

� The dovish rhetoric from the ECB tends to put more probability on a QE extension in either October or December

� The recent decline in US nominal yields is largely due to a downward revision of inflation expectations.� Nevertheless, inflationary signs should be watched closely as they will foreshadow a steepening

decline in govies.

� We expect negative total returns on USTs. We still look for the bear market on USTs to resume.� We remain Neutral on USTs as far as the 10-year yield stays below 2.30. We wait for a material

break either above 2.35 or below 2.00 to change our positioning� Our ultimate target on 10y yields stands at 2.75 by end of 2015.

� On German Bund, we remain Neutral. as long as the 10-year yield stays above the 0.45 – 0.50 area.� We will switch to UW again as the 10-year yield breaks above 0.80-0.90

� Inflation breakevens have risen since the start of the year. We remain OW HICP Inflation through 5y inflation swaps (long HICP inflation breakevens = receiving HICP vs payind fixed rate) as we expect a steady pick-up in HICP inflation over 2H15

� We expect TIPS to underperform as energy prices continue to decline and Fed tightening tends to push real rates up in the absence of accelerating inflation.

FinLight Research | www.finlightresearch.com

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� The Chinese turmoil and expectations of substantial IG supply have weighed on corporate spreads over the past 2 months.

� Credit quality further deteriorates in Q3, both in IG and HY, as the releveraging continues to rise at a sustained pace (especially in HY space)

� August has not been kind to the HY market. With the Chinese hard landing fears resurfacing, pressure resumed on commodity prices, pushing down credits in the Energy, Metals & Mining sectors, especially in US HY

� We feel more cautious about EUR HY despite the prospects of further easing by the ECB. Next QE should drive a rally in European credit over the near term, but long positioning is getting crowded and liquidity scarce

� We remain UW on corporate credit, due to valuation, to rising corporate leverage (specially in the US), to rising volatility, to position within the credit cycle and given the weak total return forecast

� We still prefer IG over HY on a risk-adjusted basis as we expect volatility on spreads to remain elevated and we believe IG corporates better positioned to absorb the impact of rising rates

� Within the credit pocket, we remain Neutral on USD vs. EUR HY spreads, but we prefer USD on a total return basis, despite its higher beta to energy sector

� We still prefer US IG over Eurozone.IG, as we think that more attractive spread valuations and higher carry should fuel a stronger bid for US credit.


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� Bottom line : UW Govies, Neutral US vs Eurozone Govies, remain long flatteners on the US yield curve and short duration in 2y USTs, UW credit, Neutral Eurozone vs US HY credit, UW Eurozone vs US IG credit, Neutral TIPS and OW HICP Inflation, UW High Yield vs High Grade, Neutral on EM corporates


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US Govies – 10y UST

� Last month, we decided to switchfrom Neutral to UW 10y USTs andmoved to 2.30 the threshold belowwhich we become Neutral again.

� We keep this same positioning rule

� Tactically, we are now Neutralagain, waiting for a break eitherabove 2.50 or below 2.00 tochange our positioning.

� We think that the risk is stillbiased to the upside on the 10yyield.

� A better labor market wouldtranslate into higher inflationexpectation later this year (or in2016) and higher LT yields.

� In order to confirm our bearishview, a clean move above 2.40-2.50 is needed..

�


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Government Yields

� Despite the risk-off dominantbehavior, government yieldsincreased over the past 2 weeks

� One possible explanation residesin the “Chinese Effect”: Chinaneeds to liquidate Treasuryreserves in order to maintain itscurrency peg, as capital outflowsincrease and market widelyexpects further devaluation in theUSD-CNY


5-year Bund Yield

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US Credit

� IG spreads have reached a 3-year peak, drivenby heavy supply and concerns about commodityprices.

� With the Chinese hard landing fears resurfacing,pressure resumed on commodity prices,pushing down credits in the Energy, Metals &Mining sectors, and putting pressure on HYbond prices

� We still prefer IG over HY (both in US andEurozone) on a risk-adjusted basis as weexpect higher volatility on spreads and webelieve IG corporates better positioned toabsorb the impact of rising rates


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European HY

� Investors’ interest in the asset class is clearly calmed down by:

� Two concerning metrics: net leverage and interest coverage� Significant outflows and rising supply� Higher proportion of issuance (37%) used for M&A and share buybacks, which is considered as

“credit negative”.


Net Leverage

European High Yield

Interest Coverage Ratio


Credit – Any Warning? Credit vs Equity

� During normal market conditions, the correlation between the S&P 500 and HY spreads is negative. Since 1997, this correlation has averaged -75% and has been in negative territory 86% of the time.

� Currently, this correlation stands at extreme positive levels (+60%), higher than those seen in 2000 and 2007. This is probably the signature of the next crisis to come.

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Credit – Any Warning? Swap Spreads

� 2-yr swap spreads acted as an advance warning of widening risk in HY spreads and fundamentaldeterioration in the broad economy

� At this stage, swap spreads are trading around 20-30 bps. No risk is seen on the horizonyet!


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EXCHANGE RATES

� The dollar rally is not over. We reiterate our bullish view on USD over the medium-term and expect a rival of the appreciation cycle of the '90s

� Historically, USD cycles have been persistent, lasting 5-6 years in the appreciation phase. We thus see further medium term USD gains against the major crosses (especially EUR and JPY) and expect a cyclical low in EUR/USD somewhere in 2016 (with the ECB tapering)

� But over the ST, and without a September hike, the uptrend on the US dollar may be damaged seriously.

� The line in the sand for the DXY index is provided by the lows of May and June. A clean break below would derail the strength phase.

� Our positioning on USD is driven by (almost) the same trading rules:� We are now Neutral on EUR-USD, as it stays between 1.1080 and 1.12. We will move to UW

again if the spot breaks below 1.1130 with 1.08 as a target, and to to OW above 1.12

� On USD-JPY, we remain Neutral for the moment, as the spot failed to hold a break above 124-125 resistance

� We remain short EM and Commodity FX


32

EUR-USD

� The 6-month correlation between EUR-USD and the spread between 2-year swap rates in EUR and USD, is back to its highest levels (around 55-60%) of 2015

� China unexpected currency devaluation sent a negative message on the global growth and raised speculation about Fed delaying its interest rates move � Decline in US$


33

EUR-USD

� EUR-USD has broken aboveits July ‘14 downtrend (around1.10).

� During the month, we movedUW as the spot broke below1.1040 and reached our firsttarget around 1.08.

� As said in our previous MonthlyReport, we moved from UW toNeutral as the spot broke above1.1080 and then to OW above1.12

� We are currently Neutral, andprefer to keep our bearishbias.

� We will move to UW again if thespot breaks below 1.1130 –target = 1.08


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COMMODITY

� The picture remains bearish in commos. despite the sharp reversal in prices (led by energy andbase metals) we’ve seen recently, and which is more about technicals than fundamentals.

� Commodity weaknesses (supply glut in oil, slowing growth in China, precious metals loosing theirluster as a safe heaven…) are likely to continue.

� The expected Fed rate hike would put more pressure on the asset class as higher interest rates put ahigher cost on holding commodities

� The next leg up in the US$ will put more pressure on commodity prices

� We remain neutral-to-bearish across all complexes in the near term. To mid-2016, returnforecasts are negative for commodities as a whole.

� We still think that it is still too early to get in the “reflation trade” of a weaker dollar and highercommodity prices

� We remain UW commodities. We continue, however, to like owning the GSCI index, and thinkthat commodities hold value as cross-asset portfolio diversifiers and as an inflation hedge.


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COMMODITY

Bottom Line :

� Base Metals: Base metals don’t appear to be stabilizing yet. We remain Neutral on base metals giventhe current weaker demand environment.� On the MT, we do not like holding Copper (even if it could go higher over the ST) as it appears

highly overvalued relative to the dollar, the global growth and the Chinese demand.� Producers should cut existing production and future projects before we can expect a sustainable

reversal in prices.� We expect base metals to trade lower for longer in order to match supply with demand.

� Agriculture: GSCI Agri posted -2.57% in August. We remain Neutral

� Energy: We remain of the view that the oil market is oversupplied, still think it is too early to expectmajor upside for the price and that the risks remain substantially skewed to the downside. The risingMiddle East production (Iran would double its oil exports to 2.3M barrels a day) and the seasonal dip inrefinery crude runs should add pressure to the market.� We moved from UW to Neutral, as the spot dropped below 42.� We will move to UW again if the WTI goes above 56.5 and to OW if the it breaks above 63


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COMMODITY

� Precious Metals: As expected, the Gold broke below its March lows and headed towards our target (980-1000), before rebounding on the 1080 level.

� We change nothing to our view on precious metals. The stimulus provided by the ECB & BoJ isalready factored in gold prices. Precious metals are vulnerable to higher US real yields,stronger dollar and weaker gold flows to Asia � We maintain the view that Q3 15 is likely to bethe weakest quarter for gold

� Applying our trading rule, we decided to switch from UW to Neutral at and below 1150, and tomove progressively to OW (accumulate) as the spot slides down.

� We are OW gold. The impulsive rebound we’ve seen in August is probably the signature of a baseformation around 1080 (to be checked), and the beginning of a corrective rally

� We will significantly increase our OW if the spot breaks above the 1150-1160 area (target 1210 andhigher)

� A clean break below 1120 would open the door for testing recent lows again. We will increase ourOW below 1060.

� We still think that Silver (like gold) is probably ready for its final leg down towards 12.50. � We are OW (accumulate) on Silver as the spot broke below the 14.70 resistance and moved

down towards 12.50. � We may increase our OW if the Silver breaks above 16.7-17 or below 13.5


37

Crude Oil

� From looking at the strong rally the crude has experienced during the last days of August, shortsqueeze and other technical factors seem to be the most rational answer.

� We see no fundamentals behind this move. We expect a consolidation to the downside.


38

Crude Oil – Tech. Perspective

� We moved UW on July 2nd.expecting WTI to retrace its recentlows of $45/bbl by October. Butour target level has been reachedearlier.

� In our Aug. Report, we decidedto go Neutral again around 42and wait to see how the spotbehaves near the previous lows.

� Since then, we are Neutralcrude. We were proved rightgiven the sharp rebound we’veseen at the end of August.

� A base formation seemsunderway.


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Gold – Tech. Perspective

� According to our trading rule(please see our previous reports),we decided to switch from UWto Neutral at and below 1150,and to move progressively toOW (accumulate) as the spotslides down towards 1000-980.

� We are OW gold. The impulsiverebound we’ve seen in August isprobably the signature of a baseformation around 1080, and thebeginning of a corrective rally

� We will significantly increase ourOW if the spot breaks above the1150-1160 area (target 1210 andhigher)

� A clean break below 1120 wouldopen the door for testing recentlows again. We will increase ourOW below 1060.


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ALTERNATIVE STRATEGIES

� The HFRI Fund Weighted Composite Index fell 1.87% in August (+0.2% Ytd). August was the worst monthly performance since May 2012. Nevertheless, the FWC index outperformed the S&P 500 by over 4% over the month (and +3% YTD). Losses were widely distributed across HF strategies. Best performers were low-beta strategies (Macro, Arbitrage, Market-Neutral Equity). The HFRI Macro: Systematic Diversified/CTA Index declined by -1.9%

� The weak performance of Macro managers was mainly due to long positions in equities and USD. Long exposure to US rates proved rewarding but the gains were more than offset by losses on long positions in European rates.

� Long-term CTAs suffered from the collapse of equities given their long exposure. They also posted losses on their long exposure to rates and were penalized by their short exposure to energy.

� We stick to our preference for risk diversifiers (pure alpha generation strategies) over return enhancers. Our strategy has been clearly rewarding during the last market turmoil.

� We believe that diversifying portfolios with an increased allocation to alternatives is particularly attractive at this stage of the cycle.

� We are not changing our recommendations on alternatives which we consider to be suited to current market conditions. We maintain our OW positioning on:� Equity Market Neutrals both for their “intelligent” beta and their alpha contribution. � CTA’s and Global Macro as a diversifier and tail hedge. These strategies should outperform as

FX and commodity current trends are likely to persist.� Vol. Arb strategy and prefer funds that trade volatility globally (all assets / all regions). This is our

way to take advantage from the higher volatility regime.


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CTA Funds

� CTAs remain our favorite HF strategy over the mid term as they provide adequatediversification benefits, and despite the fact that their current positioning (neutral to short equities,long govies, long USD and short commodities) is vulnerable to a market rebound.

� This strategy is well designed for the current context of aging bull market for both equities and bonds.


Source: Attain Capital

Bottom Line: Global Asset Allocation

� As trumpeted for months now, Chinese economy was the eye of the

storm. Concerns about its growth and fears of global

recession/deflation triggered the panic on the global capital markets

� The deflation and growth scares morphed into a vicious cycle over the pastfew weeks.

� Our sentiment is that the risk-off tide is rising. The market sharp sell-offsuggests that something big is indeed unfolding. The bull market is probablynot broken but seriously damaged.

� The long-awaited (10-15%) correction on stocks has finally occurred. But westill believe that equity markets are living on borrowed time

� The last time markets experienced the type of volatility that we are currentlywitnessing across all asset classes was in 2008. The volatility regime

switching we’ve been signaling for months is finally confirmed.

� Anticipation of rising interest rates will contribute to fear and volatility in thestock market. The last payrolls report keeps a September hike on the table

� We maintain our view that commodities will underperform, US$ will continueits rise, and volatility will remain high.

� A confluence of forces are converging to disrupt global equity and debtmarkets.

� We reiterate our view: A perfect storm is building… It combines historicallyovervalued stocks with stretched government bonds and corporate credits.Unlike previous storms (2000, 2008), investors would be left with almost

no place to hide

� We summarize our views as follows �


43

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.

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� Our expertise expands along 3 axes:

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Finlight Research - Market Perspectives - Sep 2015

Economy & Finance

Transcript of Finlight Research - Market Perspectives - Sep 2015