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May 2014 - The Macro Picture Strengthens



The macroeconomic backdrop appears to be improving as we move into the equity bull market’s fifth year. An improvement in economic data, both in the U.S. and Europe, has reduced some of the market volatility and macro uncertainties which weighed on equities earlier this year. Equities continue to offer the highest risk premium and we remain confident in our call at the beginning of this year that markets will continue to grind higher.


That being said, there remains the potential for higher volatility and another bout of risk aversion—not unlike what we saw earlier this year—in the near term. For one, the situation in Ukraine remains fluid with a high degree of uncertainty. A flare-up in tensions in Eastern Ukraine, including a Russian incursion or a new round of stronger sanctions aimed at Russian banks and energy companies— could be the catalyst which induces another market correction.


Though this would dampen risk appetite, we believe that demand for higher-quality, value stocks will remain strong and could lead to a larger outperformance as investors rotate out of the higher beta “momentum” stocks.


In April, this theme began to be played out, mainly in U.S. equity markets where an improvement in macroeconomic data was accompanied by a significant shift in style leadership among equities. Value outperformed the higher-flying growth stocks—namely in technology and biotech. We do not view the decline in momentum stocks as negative for equities going forward.


Following the weather-related soft patch in 1Q 2014—as evidenced by the meager 0.1% growth in GDP following a 2.6% expansion in 4Q 13—macroeconomic data in the U.S. has firmed. In April, the U.S. economy added 288,000 new jobs, the most since 2012 while the unemployment rate fell from 6.5% to 6.3%. The labor force participation rate continued to fall, suggesting there is still slack in the labor market. The strong jobs reading is consistent with recent comments from Federal Reserve Chairwoman Janet Yellen about a pickup in economic activity following the winter freeze. In its most recent policy meeting, the Fed continued to taper is large-scale asset purchase program by $10 bn to $45 bn a month.


Indicators measuring industrial production and manufacturing both rose in March. Corporate earnings have strengthened with 74% of companies reporting earnings above the mean estimate. We are also seeing a very strong pick-up in M&A activity which is providing additional confidence to markets.


Across the Atlantic, the economic picture in Europe continues to improve. A preliminary reading of manufacturing activity hit a three-month high in April. Financial conditions also continue to improve. Results of the latest European Central Bank (ECB) quarterly lending survey showed a stabilization in credit conditions in 1Q 2014 as lending to businesses and households showed a sequential improvement. Sovereign risk continues to compress as well. Spreads on Irish debt have fallen to pre-crisis levels while spreads on Spanish debt are trading close to historic lows.


At the risk of sounding like a broken record, inflation in the Eurozone remains stubbornly weak. In April, inflation rose to 0.7% from 0.5%, still well under the target of “below, but close to 2%”. The ECB remains on the sidelines, though we believe that recent data—combined with a strong euro—strengthens the case for the Central Bank to take additional, non-conventional measures to ease monetary policy and boost prices pressures. We remain constructive on European equities and prefer value stocks while remaining cautious towards companies with significant EM and Russian exposure.


In Japan, disappointing macro data was a likely reason for equity market underperformance. The Bank of Japan (BoJ) lowered its growth forecast, mainly due to a decline in net trade as the country’s import bill and moderate global growth weighs on exports. While 2Q 14 GDP is expected to be weak, there should be a pickup in 2H 14. We believe that additional easing from the BoJ remains likely, and will support equity markets—especially if the program includes purchases of risk assets such as ETFs.


The near-term view is cautious towards Chinese markets as the reforms undertaken by the government have slowed growth and are without the major stimulative antidotes witnessed in 2008. Meanwhile, concerns over the proliferation of credit by “shadow banks” and China’s property market has cast a gloomy sentiment over Chinese markets. While we remain constructive in the medium -term, we await new catalysts to alter the macro view surrounding Chinese equities.


The HY credit market performed well in April as the search for yield continued to narrow spreads. Demand for this asset class was evidenced by the record 12.1 bn euro issue of debt by French telecom operator Numericable and its parent company Altice, which broke the record for a single sale of HY debt. In the U.S., spreads are approaching the lows seen in previous cycles. We believe that this asset class will remain firm, but are cognizant that idiosyncratic risks remain, despite the fact that corporate defaults remain low. For this reason, selectivity in name picking is critical to extract additional gains.


A high degree of volatility across financial markets is likely to persist throughout 2014 as we transition into a "new normal" of a less expansionary Fed and heightened geopolitical and emerging market risk. That is why a proper regional and sector selection strategy, combined with rigorous risk-management should remain the decisive factor for investment performance. As usual, don’t hesitate to contact us to discuss investment performance or financial markets more generally.