Note October 10,2019: Q4/2019 – Markets in Likely Transition: The capital market performance of the last twelve months differs from the popular day- to-day often dwelt upon. In the summer of 2019 amid expectations of slower growth and more quantitative ease, global fixed income yields have declined, even into negative yields for several European sovereign bonds. Still, that rotation has not had junk bond yields nor equities moving in lockstep with lower sovereign bond yields which instead have spawned volatility.
Several major central banks appear to be targeting more quantitative ease to boost growth but the impact remains uncertain as internal dissension rises. Political uncertainty seems elevating again in the Middle East, includes impeachment tussles in the electioneering United States, with dissension in Europe and tensions in several parts of Asia. Discordant domestic politics have reared for three of the largest financial centers, New York, London and Hong Kong. Impact on new offerings needs watching.
Momentum dispositions continue in capital markets whether in algorithmic trading, ETF activity or more classical forms. Fiscal deficits closing on $1 trillion appear in the United States and are elevated elsewhere. Negative yield sovereign fixed income apparently is close to $14 trillion in value. In otherwise underweight fixed income, we prefer short to medium term U.S. dollar and other currency holdings such as in Canadian and Australian dollar sovereigns as well as high quality corporate fixed income worldwide with positive yields instead of the negative yield variety that would benefit most from unchanged momentum.
In equity markets rationalizing appears of movements as being a derivative of the administered decline in interest rates and the suppression of fixed income yields. As well, higher dividend yields of indices like the S&P 500 and individually globally over U.S. Treasuries have received attention. Still, inter day and intraday equity market swings have been large. As corporate releases loom, consensus earnings expectations seem reduced. At present, valuations in equities seem elevated. The role of risk premiums is to provide a cushion, especially for unknown risks. We believe the political environment as well corporate assessments, individually and globally presage more selectivity in security, sector and geographic selection.
Amid selective credit stress, financials remain globally critical in equities and we favor the strongly capitalized. For defensiveness and value, we prefer stronger Information Technology over the traditional but currently hard pressed Consumer Staples. Despite recent weakness, we prefer to overweight Industrials over Consumer Discretionary in the cyclicals. We do prefer industrial alternates but overall have REITs and Utilities as underweight despite the consensus penchant for yield. We have Communications Services at underweight on concept media pressures, have Healthcare at market weight instead and favor strongly capitalized Energy.
Despite valuation and due to its heavy weight in Consumer Staples, Europe is unlikely to wrest market leadership from the United States. While we have above average cash weightings in asset mix, within equities we also favor the selection and diversity of the U.S. market, Japan appears interesting on restructuring and for growth, as do high quality emerging market securities.
Exchange rates between the major advanced countries appear relatively stable, potentially ephemerally so. Aggregate emerging country fixed income yields seem closer to 12 month lows but currency crises have appeared especially in Latin America and beyond. It suggests systemic risk to be global. We espouse higher than benchmark asset and equity weightings in precious metals and cash.
Asset Mix
In the last quarter of 2019 and onward, we expect markets continue transition. The capital market performance of the last twelve months differs from the popular day- to-day so often dwelt upon. In the summer of 2019, amid expectations of slower growth and more quantitative ease, global fixed income yields declined substantially, even into negative yields for several European sovereign bonds. Still, that rotation has not had junk bond yields nor equities moving in lockstep with lower sovereign bond yields spawning volatility.
Several major central banks appear to be targeting more quantitative ease in order to boost growth prospects but the impact remains uncertain with internal and external dissension rising. Political uncertainty seems elevating again in the Middle East, includes impeachment tussles in electioneering United States, dissension in Europe and tensions in several parts of Asia. In a summer of discord, domestic politics have reared for three of the largest financial centers, New York, London and Hong Kong. Impact on new offerings needs watching.
With current politics fractious, misjudgments are likely to be costly for markets and growth. The impact is likely to be more conflicted than appears incorporated in markets still mesmerized by quantitative ease expectations. Political pressure points of contention include internally in Italy, Brazil and Britain as countries; Britain and Europe as well as between Japan and South Korea on their intertrade; China and the United States over global trade. There is ongoing stress being expanded across the Levant to Iran to South Asia, all with crucial trade routes at risk of fracture. Recent reports indicate that global trade has been slowing.
Global growth in GDP appears slowed into the 3% annual level according to some estimates such as those from the OECD and with the IMF widely expected to further reflect on its summer view of slowed growth. In the late summer of 2019, central banks appeared espousing more quantitative easing but interestingly not including the Bank of Japan as well as with internal and external dissension. The leading edge of further quantitative ease appears to be from the European Central Bank that includes newer rounds of bond purchases as well as administered rate cuts but with now vocal dissension internally, from former officials and from major constituent central banks, including the Bundesbank, the Bank of Netherlands and several others. After tightening into late 2018 to vacillation expanding in mid-2019, the Federal Reserve has now cut its Fed Funds rate by 25 basis points to 2%, left open resumed securities purchases but has expounded upon a watch and see approach. Its latest FOMC and Beige Book statements have also reflected that a divergence of views within has expanded. Interestingly, while administered rates in the United States remain noticeably positive (as is the case in Canada and Australia among others) and while those in Japan and Europe are noticeably negative, the exchange rates between the major advanced countries appear relatively stable.
The capital markets have had continuation of the momentum dispositions of this cycle whether in algorithmic trading, ETF activity or in more classical forms. In recent months in fixed income markets, negative yields have spread well beyond Japan and Switzerland and are now commonplace for many European sovereign bonds. Fixed income yields have also declined to twelve month lows into emerging country aggregates and BBB Corporate but not so for the CCC Corporate fixed income.
The sustainability of negative yield holdings has yet to be tested in the event fixed income yields were to rise. Investment portfolios have long been marked to market. Emotions as well as management/client pressures could again swing herd behavior. Fiscal deficits closing on $1 trillion appear in the United States and are elevated elsewhere. Negative yield sovereign fixed income apparently is close to $14 trillion in value. In otherwise underweight fixed income, we prefer short to medium term U.S. dollar and other currency holdings such as in Canadian and Australian dollar sovereigns as well as high quality corporate fixed income worldwide with positive yields instead of the negative yield variety that would benefit most from unchanged momentum. Currency risk versus capital gain anticipation has yet to be tested especially for negative yield or long duration such as 100 year maturity fixed income.
In equity markets, rationalizing appears of movements as being a derivative of the administered decline in interest rates and the suppression of fixed income yields. Seen in that context, the higher dividend yields of indices like the S&P 500 and individually over U.S. Treasuries States have received attention. Notwithstanding such predispositions, inter day and intraday equity market swings have been large. Consensus earnings expectations are being reduced. Another set of corporate releases looms. At present, valuations in equities seem elevated. The role of risk premiums is to provide a cushion, especially for unknown risks. We believe the political environment as well corporate assessments, individually and globally indicate a more selective process imminent in security, sector and geographic selection in equities.
Exchange rates between the major advanced countries appear relatively stable, potentially ephemerally so. In aggregate, emerging country fixed income yields do appear closer to 12 month lows but currency crises have appeared especially in Latin America and beyond. It suggests systemic risk to be global. We espouse higher than benchmark asset and equity mix weightings in precious metals and in cash.
Equity Mix
The reality of equity valuation being elevated cannot be justified only on a lack of alternatives. Cash and hedging are options. Elevated equity valuations do in all likelihood indicate some optimism about earnings growth as well as comparisons to admittedly suppressed benchmark fixed income yields led by the United States, Europe and Japan. Even when precise risks cannot be pinpointed, equity risk premiums are likely to currently have and have had an appropriate, sometimes forced role.
More volatility in corporate delivery looms. Earnings such as for the S&P 500 are already advanced well beyond the steep acceleration experienced early in a recovery phase and currently are in a more mature expansion phase below the long term of 7% annually. In the immediate quarters upcoming, year-over-year earnings are likely to be under pressure from slower annual economic global GDP growth of closer to 3%. Across sectors as a late cycle phenomenon in company reports, bifurcation in delivery from competition also seems steep. In the latest iteration of corporate commentary on their delivery of results and ranged from Information Technology to Consumer Staples and Discretionary, some individual companies have already been reporting gains in advantage, while others discuss weakness and the need for restructuring. As a classical late cycle phenomenon, differences in management capabilities appear as likely being magnified not least within industry segments. After years of disdain, security selection is likely coming to the fore.
Assessed over 12 months rather than the penchant in this cycle for day-to-day momentum, equity markets like the S&P 500 and others seem in a sideways correction. Corporate reporting will soon be globally widespread, especially being earlier in view in the United States than for many others. Valuation notwithstanding and unlike some geographic assessments, global equities have yet to break from U.S. developments. Amid volatility, value appears to be doing better than concept.
In equities amid selective credit stress, Financials remain globally critical. For defensiveness and value, we prefer stronger Information Technology over the traditional but currently hard pressed Consumer Staples. Despite valuation and due to its heavy weight in Consumer Staples, Europe is unlikely to wrest market leadership from the United States. While we have above average cash weightings in asset mix, within equities we also favor the selection and diversity of the U.S. market. After many years of denial, domestic realities and global competitive pressures have forced more widespread restructuring in business and in corporate governance in Japan which also appears interesting. On restructuring and for growth, high quality emerging market securities also have favor for us.
We regard the Financials as being crucial for the direction of capital markets. Credit quality and impairment recognition remain issues that seem especially acute in Europe and Asia. We overweight the Financials but favor those that are stronger capitalized as the sector is still in restructuring. Currency stability among the major advanced zones may prove ephemeral. In some emerging countries, both currency and interest rate pressures already exist. We see precious metals in Materials as an attractive overweight both at the equity sector and asset mix levels.
While facilities to transport and produce cleaner energy and water have attractions, we are overall underweight Utilities on the specter of fixed income volatility rising. Despite recent weakness, we prefer to overweight Industrials over Consumer Discretionary in the cyclicals space. We do prefer industrial alternates but overall have REITs as underweight despite the consensus penchant for yield.
We believe that business and market developments give rise to an attractive mix of growth, financial strength and yield to be favored in Information Technology with an overweight in current comparison with Consumer Staples. We have Communications Services at underweight but do favor telecommunications and entertainment as beneficiaries of flux.
Healthcare did have a bout of restructuring and merger euphoria from biotechnology to devices to facilities. Healthcare then has been becalmed in a period of post – Merger and Acquisition (M&A) delivery requirements. It gives rise to opportunity to build Healthcare market weightings. We favor an overweight in Energy but in the management of risk, the advantages likely lie with those strongly financed and business diversified.
Communication Services: In the telecommunications and entertainment portion of Communications Services, amalgamation has already led to activist pressures in favor of streamlining and divestiture in order to unlock value. In telecommunications, reducing their global footprint especially in legacy assets and reducing duplication have been the industry priorities for several years of merger and acquisition activity. We have favored focus on strong balance sheet and revenue companies over concept oriented entities. However, the social media portion of Communications Services faces regulatory challenges that are now likely to include political scrutiny amid strong election activity, not least in the United States and Europe. While favored in momentum positioning, a lack of revenue heft seems to us as a likely challenge for social media companies. Amalgamating both, we have Communications Services at underweight but do favor telecommunications and entertainment as beneficiaries of flux.
Consumer Discretionary: Much as in the past, the U.S. consumer has proven to be much more resilient and more willing to spend than their counterparts in other countries, especially those in advanced countries. It has likely been a crucial element in global recovery earlier in the cycle but also in stabilizing the global economic growth experienced in recent quarters. In the trade tussle between the United States and China, tariffs represent new challenges in the form of rising costs. In distribution across the production consumption chain, it remains to be seen as to how these costs are absorbed. Meanwhile, at the point of sales end around the world and from the luxury to common goods spectrum, it would appear that classical elements of selectivity are emerging. Those purveyors who accurately judged demand have benefitted for instance over even those equal in quality but who misjudged even small variations in style. As well, in advanced and in emerging countries, overbuilding of malls and the need to switch space to include entertainment appears as being an imperative. We anticipate more selectivity in Consumer Discretionary, have it as underweight but do favor entertainment.
Consumer Staples: One salient aspect of this investment cycle has been the dramatic impact of quantitative ease and especially reduced administered interest rates in major advanced countries on demand and portfolio preferences for yield. In emerging countries, increased aspirations for global products has also been substantive. Both these developments have meant that far from being sedate, valuation in Consumer Staples expanded early and substantially. Both detract from Consumer Staples as being seen as still classically defensive investments. Further, within many business segments of Consumer Staples, sharp bifurcation in delivery can be seen. It benefits those corporations earlier and most thoroughly into restructuring both brand proliferation and packaging strategies. Such changes can take years to yield results. Those resting on laurels and anticipating benefits from tweaking legacy brands have recently suffered. We are underweight Consumer Staples.
Energy: While global politics have recently included the seizure of oil tankers, threats to free passage in the Persian Gulf and production problems in the Americas, crude oil prices have been relatively sedate at currently close to $53/Bbl. WTI, compared to a range in recent years of $145 – 25/Bbl. WTI. Equity prices in the energy space have recorded poor performance. Attributions can be made from the slowing of global growth in many economies affecting demand as indicated by the International Energy Agency. As well, individual company budgetary pressures such as in shale oil have appeared forcing up production at elevated levels for cash flow to finance budgets. We believe that the substantive transfer is some time away of energy utilization from hydrocarbons to alternates. It may be several decades away when it comes to crucial products such as plastics or healthcare dependent on derivatives of hydrocarbons, artificial or otherwise. Our assessment on crude oil pricing has been that $ 60 – 70/Bbl. WTI represents likely balance on both politics and competition within and without. As such, we favor an overweight in Energy but also emphasize strong balance sheets and the management of risk. The advantages likely lie in Energy with those strongly financed and business diversified. They have additional advantages in being likely to acquire assets from more hard pressed compatriots.
Financials: We regard the Financials as being crucial for the direction of capital markets. Taking into account both recent and decade long developments in the financials industry, the advantages are likely to continue to lie with those that have been earliest and most committed to implementing restructuring. It is an aspect that globally has favored U.S. based entities. European and Asian financials still appear especially pressed on credit impairment recognition in existing portfolios. It is noteworthy that after looking in askance when quantitative ease was implemented in Japan over two decades ago, many countries have then followed suit for over a decade. The European Central Bank in September 2019, not only resurrected bond purchases but also moved deposit rates to further negative levels. Major European sovereign bond yields are amongst the most negative globally. Net Interest margin pressures remain in banking and cost cutting has ensued. Credit quality issues appear in major emerging economies like China and India as well as even more so in several others. We see these aspects as making revenue and earnings growth more challenging in traditional financials and accentuating favor for those able to generate the same from alternate channels such as those in investment banking. We overweight the Financials but favor the stronger capitalized.
Healthcare: Recently,Healthcare companies including those in the devices space have been subject to the vicissitudes of lawsuits and funding uncertainties. Still and amongst those often placed in the same defensive space, we rate Healthcare as market weight compared to underweighting Consumer Staples. Our rationale is that even compared to market valuations, those of Consumer Staples became elevated earlier in this cycle and it was partly due to the penchant for yield in an environment of suppressed interest rates that includes negative yields. Globally, the business space for Consumer Staples has once more become littered with misplaced product line strategies ranged from brand proliferation to packaging. Consumer Staples are likely not as defensive as being assumed from the past. In contrast, Healthcare did have a bout of restructuring and merger euphoria from biotechnology to devices to facilities but then has been becalmed in a post – Merger and Acquisition (M&A) period of delivery requirements. It gives rise to opportunity to build Healthcare market weightings.
Industrials: From still depressed capital goods expenditure plans by companies to product deficiencies in aircraft to tariff wars among economic zones to public infrastructure programs still to be fully formed in many countries, there has been much uncertainty for companies in the Industrials space. Howsoever, Industrials also contains companies with many and diverse products that are used by consumers and industry alike but only sometimes garner the commonplace profile of large ticket items like aircraft. Among the more cyclical sectors also and in being early cycle beneficiaries, those in Consumer Discretionary have had more profile but face pressure ranged from aspirational activity in emerging regions to spending patterns in advanced countries. Despite recent weakness, we prefer to overweight Industrials over Consumer Discretionary in the cyclicals space.
Information Technology: Information Technology has long been regarded as being a mix between capital investment with connotations of cyclicality and growth with connotations of concept euphoria. Restructuring has often been severe as technologies and demand have evolved. In the markets, Information Technology has often been given the moniker of being in the growth as opposed to the value or defensive segment of portfolio investment. We believe there have been two significant developments at variance with such assessments. First, the bubble and then collapse in 1999/2000 of concept euphoria in Information Technology led to severe restructuring even by industry standards. It led in parts of Information Technology to focus on balance sheets and product revenue delivery rather than on concept aspects like so-called eyeball measurement that had proven ephemeral in delivering revenue. Second and in index allocations, aspects of social media with concept shadings were transferred to Communications (to be placed with Telecomm Services). We believe that these business and market developments give rise to an attractive mix of growth, financial strength and yield. We favor Information Technology with an overweight with an underweight instead for Consumer Staples.
Materials: Materials companies have had to restructure year-upon-year after the excess of the last cycle of asset and merger acquisitions at elevated prices when global GDP growth was closer to 5%. Now, climate change pressures add to concerns for industries like coal overall as well as in several legacy mining techniques in other basic materials. Many global GDP growth projections such as from the OECD and potentially on releases from the IMF suggest the risk of a slowdown, possibly closer to 3% annually. Cyclicality has long been the bane of basic materials. The current situation is no exception. However, we believe that the excess euphoria is absent which in previous cycles led to companies in essence purchasing assets at peak of cycle prices. In other aspects for the Materials space, political uncertainty seems elevated not just in wars in the Middle East but also in domestic pressures within the United States ahead of elections and impeachment threats; in Europe from BREXIT and internal individual country pressures; and in Asia in many regions. Monetary policy and quantitative ease reliance appears once more in major central bank strictures but their efficacy seems unknown, after a decade of such. Currency stability among the major advanced zones may prove ephemeral. In some emerging countries, both currency and interest rate pressures already exist. We see precious metals as an attractive overweight both at the equity sector and asset mix levels.
REITs: Excess capacity in shopping malls have become an emerging country issue with a surfeit of more recent expansion and an advanced country issue amid a reality decades long legacy. Especially for millennials and younger cohorts, consumer preferences appear to be evolving to favor for entertainment, experiences and a combination of online/physical space retailing. Pressures such as the ability to service debt and manage cash flow are consequently current issues of relevance in such long dated assets as shopping malls. Similar transition pressures could be an issue for commercial space with respect to shared office space concepts, as seen for instance in major centers like New York. We do prefer industrial alternates but overall have REITs as underweight despite the consensus penchant for yield.
Utilities: Even more so as fixed income yields declined in the summer of 2019, consensus has also appeared to prefer Utilities as defensive elements and as purveyors of yield for investors. Aspects such as over $14 trillion apparently in negative yield sovereign bonds do raise the specter of rising fixed income volatility which would likely in turn adversely affect equity performance in Utilities. Further, climate change pressures from consumers are likely to raise the pressures on Utility companies to spend to build up more modern facilities with greater safeguards than those in their legacy assets. It would favor suppliers such as in the Industrials space but also place capital pressures on Utilities. While facilities to transport and produce cleaner energy and water have attractions, we are underweight overall Utilities.
Asset Mix
Global U.S.
Equities-cash 52% 57%
-priv. 6 6
Fixed Income 25 20
Cash 12 12
Other 5 5
Total-% 100 100
Geographic Mix
Currency/ Equities Fixed Cash
Real Income
Americas 61% 65% 67% 55%
Europe 22 20 26 37
Asia 9 13 6 3
Other 8 2 1 5
Total -% 100 100 100 100
Global U.S. Stance
Comm. Serv. 8.0 % 7.5 % Under-weight – favor telco, enter.
Cons. Disc. 5.0 6.5 Under-weight – favor travel resort
Cons. Stapl. 5.0 4.0 Under-weight as restructuring
Energy 12.0 13.0 Over-weight via strong companies
Financials 19.0 16.0 Over-weight restructuring leaders
Healthcare 9.0 12.0 Market-weight focused on delivery
Industrials 13.0 13.0 Over-weight for capex recovery
Info. Tech. 17.0 19.0 Over-weight tangible prod./serv.
Materials 8.0 5.0 Over-weight esp. precious
REITS 2.0 2.0Under-weight esp. retail space
Utilities 2.0 2.0 Under-weight – favor pipelines
Total-% 100.0 100.0 () prior weight StrategeInvest’s independent consultancy operates as Subodh Kumar & Associates. The views represented are those of the analyst at the date noted. They do not represent investment advice for which the reader should consult their investment and/or tax advisers. Any hyperlinks are for information only and not represented as accurate. E.o.e.